Charting the New 3.8% Investment Tax Waters

(c) net gain attributable to the disposition of property other than property held in a trade or business not described in (b), above.

"Substitute income" and "substitute dividends" are also included in net investment income under the proposed regulations, because, as explained in the preamble to the regulations, such income could otherwise be used to facilitate tax avoidance. Though the IRC exempts income obtained in the ordinary course of a taxpayer's trade or business, the investment income tax specifically does apply to trade or business income if the trade or business is considered to be a passive activity of the taxpayer or involves trading in financial instruments or commodities.

In some cases, the additional 3.8 percent tax can apply to a sale of the taxpayer's primary residence; as such a sale would represent a disposition of property that is not held in the taxpayer's trade or business. Further, income derived from a taxpayer's passive activities, such as income generated from participation in a partnership, may be subject to the investment income tax.

Net investment income includes a trust beneficiary's share of the trust's distributable net income to the extent that the income is properly characterized as net investment income. Amounts received from Social Security, 401(k) plans, IRAs, pensions and similar retirement income sources are not included in net investment income.

Q: Who is liable for paying the investment income tax? 

For tax years beginning after December 31, 2012, a 3.8 percent tax must be added to the tax rates already in effect for certain investment-type income received by higher income taxpayers.

The 3.8 percent tax on net investment income applies for taxpayers with annual adjusted gross income (AGI) of more than $200,000 for single filers, $125,000 for married taxpayers filing separate returns or $250,000 for married couples filing jointly. Unlike many other threshold amounts, these thresholds are not indexed annually for inflation.

This 3.8 percent will be added to the rates currently in effect, increasing the capital gains and dividend tax rates for many taxpayers (the rate will increase from 20 percent to 23.8 percent for taxpayers in the 39.6 percent income tax bracket and from 15 percent to 18.8 percent for taxpayers in lower tax brackets). The tax applies both to individuals and to certain trusts and estates. Nonresident aliens are not subject to the tax. 

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