Net investment tax

The Patient Protection and Affordable Care Act (also known as “ObamaCare”) has many new and different types of taxes to finance the law, starting on different dates.

One of these new tax regimes — the “ObamaCare 3.8% Medicare surtax on unearned income” — affects upper-income traders and investment managers as of Jan. 1, 2013. It only applies to individuals with modified adjusted gross income (AGI) exceeding $200,000 (single), $250,000 (married filing jointly) or $125,000 (married filing separately). (Modified AGI means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.)

Final IRS regulations and tax form 8960 instructions were late 
The IRS released its final regulations for “net investment income” (NII) and “net investment tax” (NIT) in December 2013, and draft instructions for Form 8960 (Net Investment Income Tax) in January 2014. The IRS was late because the proposed IRS regulations were highly problematic for many CPAs and industry groups who submitted comments asking the IRS for many changes. The proposed regulations disenfranchised taxpayers from deducting their losses against NII which was unfair and against the spirit of the tax code.

Thankfully, the final regulations are better. We are pleased with the results for business traders, who went from being the most disenfranchised to the most enfranchised. Unlike most taxpayers with NII, business traders may deduct trading business net losses and expenses against NII.

What’s included and excluded from NII?
Notice the term “investment income” is used in lieu of “unearned income.” People who receive “earned income” from a job pay FICA (on the social security base amount) and Medicare on their wages or self-employment income. In general, unearned income includes interest, dividends, rents, royalties, capital gains and distributions from companies in which you are passive. Now, this type of income is subject to Medicare taxes, too — albeit at upper-income brackets only.

NII’s proposed regulations interpreted the tax code to require segregation of different types of unearned income into three different buckets, for the main purpose of disenfranchising taxpayers from using losses from any given bucket. The final regs make some serious amends here and the Section 475 MTM trader fares very well…

The NII buckets include the following:
Bucket 1: Portfolio income (includes interest, dividends and annuity distributions), royalties (net of oil and gas depletion expenses) and rents (net of depreciation);
Bucket 2: Passive activity income and loss from pass-through entities;
Bucket 3: Capital gains and losses from the sale of property not used in an active business. In the final regs, the IRS moved trading businesses into bucket 3, so trading business capital gains and losses are counted with investment capital gains and losses. Smart move!…..

There may be even better news, too 
The regulations state: “To minimize the inconsistencies between chapter 1 and section 1411 for traders, the final regulations assign all trading gains and trading losses to section 1411(c)(1)(A)(iii). The final regulations also permit a taxpayer to deduct excess losses from the trading business of a section 475 trader from other categories of income. Part 5.C of this preamble describes the treatment of those excess losses.”

This is an excerpt from Chapter 15 of Green’s 2014 Trader Tax Guide.