What is Net Investment Income Tax?

Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s, also known as Like-Kind Exchanges, are among the most powerful tax planning tools available to real estate investors. A properly structured 1031 exchange can potentially defer four levels of taxes – federal capital gains tax, federal depreciation recapture tax, state tax, and net investment income tax. While most people understand capital gains and depreciation recapture taxes, there is some level of confusion regarding the net investment income tax.

Net Investment Income Tax Overview

The Net Investment Income Tax came about as part of the Health Care and Education Reconciliation Act of 2010, amending the Affordable Care Act, sometimes called “Obamacare Act”, effective as of January 1, 2013.

Net investment income tax is tax that applies to only to Net Investment Income. In general, Net Investment Income (NII) includes interest, dividends, capital gains, rent and royalty income, and other items specifically outlined in IRC Section 1411. The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain s from the sale of stocks, bonds, mutual funds, investment real estate, interests in partnerships and S corporations, along with capital gains from mutual fund distributions are also included in NII.

Wages, unemployment compensation, Social Security benefits, alimony, tax-exempt interest, self-employment income and other items outlined in Section 1411 are specifically excluded from NII. NII also does not include any amount that is covered by the statutory exclusion under Section 121 related to the sale of a primary residence, which excludes the first $250,000 of gain recognized on the sale of a residence by an individual, or $250,000 in the case of a married couple.

Who Pays Net Investment Income Tax?

The Net Investment Income Tax (“NIIT”) is 3.8% applied to the net investment income of individuals, estate, and trusts that have income above limits set by the statute.

When the investor owns their real estate in a single-member limited liability company (LLC), that LLC is usually treated as a disregarded entity for income tax purposes. Thus, the investment income is reflected on the individual’s personal income tax return, and remains subject to the NIIT. However, multi-member LLCs are treated as partnerships for income tax purposes, and the distributions of the partnership’s business income are typically treated as self-employment income, which is exempt from the NIIT.

How is Net Investment Income Tax Calculated?

Individuals and married couples who have net investment income, will owe NIIT if their modified adjusted gross income is above these limits:

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It is recommended that you review any tax related information with your tax and/or legal counsel to determine whether the NIIT applies to your specific situation.

For purposes of the NIIT, modified adjusted gross income (MAGI) is the taxpayer’s adjusted gross income (Form 1040, Line 37) increased by the amounts of certain specified deductions or other exclusions. A shorthand analysis would be that if an individual reports income over $200,000 on their tax return, or a married couple reports income over $250,000, the NIIT probably impacts them.

A couple of examples may assist in understanding the application of the NIIT:

1. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer , a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer ’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold. This (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer is not subject to the Net Investment Income Tax.
    
2. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer , a single filer, has $180,000 of wages. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer also received $90,000 from a passive partnership interest, which is considered NII. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer ’s modified adjusted gross income is $270,000. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer ’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%).

As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before the first closing that will effectively start their Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified  A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.