How Will the New 3.8% Investment Tax Affect You and Your Clients?

The reality of higher taxes is here. The new 3.8 percent net investment income tax imposed by Section 1411 (T.D. 9644 and REG-130843-13) is in effect and imposes a tax equal to 3.8% of the lesser of an individual’s net investment income for the tax year or the excess (if any) of the individual’s modified adjusted gross income for the tax year over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately and individuals who earn adjustable gross income of more than $200,000. The tax also applies to estates and trusts, with different threshold amounts.

New Investment Tax

How will new investment tax affect you and your clients

On Nov. 26, 2013, the IRS issued final regulations giving guidance on the application and computation of the 3.8% net investment income tax. The recent proposed regulations recommend various additions and modifications to the final regulations, including guidance on certain reserved paragraphs in the final regulations. They propose special rules for certain partnership payments; govern the treatment of certain capital loss carry forwards; and deal with the treatment of income and deductions from common trust funds, related to residual interests in REMICs, and from certain notional principal contracts. They also provide rules for the use of the Section 664 system for applying Section 1411 to income recipients for charitable remainder trusts with income from controlled foreign corporations or passive foreign investment companies, but allow the use of the simplified method that was included in the 2012 proposed regulations for these purposes.

The topic of determining the gain or loss on the disposition of interests in partnerships or S corporations is reserved in the final regulations and is dealt with in the proposed regulations. The final regulations were effective Dec. 2, upon publication in the Federal Register, and generally apply to tax years beginning after Dec. 31, 2013.

This time of year, clients are meeting with their independent financial advisors to make portfolio adjustments with the goal of minimizing their 2013 income tax liability and positioning themselves for the coming year. Clients hit with tax increases could get big surprises next April, such as an unexpected tax bill or an Internal Revenue Service penalty for underpayment. With the year almost over, now is a great time to update your clients’ 2013 income projections, estimate the federal tax liability and compare it with their withholding and estimated taxes.

It’s a complicated tax and careful planning is required to properly minimize it. Investment managers should be aware of the new tax rules that will affect their funds as they explore year-end tax planning for 2013.  With so much at stake, many advisors are going to look to keep income off their client’s tax return. This can be accomplished in many ways, of course, including maximizing contributions to qualified retirement plans and taking losses to offset gains.

Real estate investors may be able to keep gains off their returns with a Section 1031 like-kind property exchange. With this technique, investors can defer all or a significant portion of their gain on one investment property by reinvesting in another, following very structured rules. Some real estate investors may be able to avoid the 3.8% surtax on their rental real estate income if they can qualify as a real estate professional under code Section 469(c)(7), and then further qualify to be considered in a trade or business for purposes of Section 1411.

To qualify, the client must devote more than half of his or her working hours, and at least 750 hours, to certain real estate activities; document the time spent on those and other activities; and meet other requirements.

On the deduction side, clients have one last shot at some breaks set to expire on Dec. 31, most notably the above-the-line deduction for teachers’ classroom expenses and the itemized deduction for state and local sales taxes instead of income taxes. For business owners (including advisors) the maximum write-off under Section 179 for equipment purchased during the year drops from $500,000 in 2013 to $25,000 in 2014. And this is the last year entrepreneurs can take 50 percent bonus depreciation on most new property.

Taxes have increased and fund compliance is more complicated. Working with a client’s tax professional on tax planning to reduce the client’s tax burden should be part of every advisor’s job. Taking steps now to plan for year-end tax challenges and opportunities, and looking ahead to next year can provide clients with the confidence they need that you are staying ahead of an ever-changing tax landscape.

For more information on Summit Brokerage Services, an independent broker-dealer, visit or contact us at (800) 354-5528.

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