Expenses that Reduce Net Investment Income

Anders has been busy blogging about the new Net Investment Income Tax and what it means to taxpayers as they begin their 2013 year-end planning.  As we have discussed in previous blogs, taxpayers with adjusted gross income exceeding $250,000 ($200,000 for single filers) will incur a 3.8% tax on some or all of their net investment income (NII). We have previously explained what types of income are included in the net investment income calculation; now we’re going to cover expenses that reduce net investment income. The proposed regulations allow your net investment income to be reduced by certain properly allocable deductions; here are a few examples:

  1. Investment interest expense – including carry forward amounts
  2. Investment advisory and brokerage fees
  3. State and local income taxes

Item three is of particular interest because it presents an interesting twist on traditional advice.  Net investment income is reduced by an allocable portion of a taxpayer’s Schedule A state and local tax deduction.  This allocation can be determined using “any reasonable method”, but the IRS has provided a safe harbor allocation based on the ratio of investment income to gross income.

When investment income is a large percentage of gross income, the reduction to NII could substantially reduce one’s exposure to the 3.8% tax.  Historically, taxpayers subject to the alternative minimum tax would not pre-pay state tax, as the deduction is disallowed for AMT purposes.  Therefore, taxpayers with large NII might rethink this conventional advice if they project to be subject to AMT on an annual basis.

It is important to note that reductions to NII are phased-out based on adjusted gross income in a manner consistent with the traditional Schedule A phase-outs.

As you can see, in order to plan for year end, it is important to understand not only what income, but also what deductions, are comprehended to arrive at net investment income. The stakes are certainly high, and thankfully you can always call an Anders advisor to discuss a tax strategy that fits your needs.