NET INVESTMENT INCOME TAX
From January 1st, 2013 taxpayers that have income above the statutory threshold amounts are obliged to pay the Net Investment Income Tax (NIIT). The NIIT applies at a rate of 3.8%. This is a tax responsibility in addition to the federal income tax.
Note: Although the tax is intended to help fund Medicare, it is in fact an additional income tax. That means that even if you are exempt from Medicare taxes, you still may be subject to the NIIT if you have Net Investment Income and also have MAGI over the applicable thresholds.
Calculation of the NIIT:
The tax rate of 3.8% applies to the smaller of
a) Net Investment Income or
b) the amount by which Modified Adjusted Gross Income exceeds the applicable threshold.
Net Investment Income is Gross Investment Income reduced by the certain deductions properly allocable to the income.
Investment income includes, but is not limited to interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer;
Investment Income does not include wages, unemployment compensation; operating income from a non-passive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, etc.
Deductions allocable to the income
These deductions include for example investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees and state and local income taxes.
Modified Adjusted Gross Income (MAGI) includes the sum of
•adjusted gross income
•Form 2555 exclusions (i.e. the foreign earned income exclusion)
•amounts of any deductions or exclusions (taken into account in computing adjusted gross income) not included in determining the amount of Form 2555 exclusions.
Additional adjustments to your AGI may apply if you have income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs).
The NIIT applies if a taxpayer has MAGI above $200,000 ($250,000 married filing a joint return or $125,000 married filing separately) and also has Net Investment Income.
Foreign Tax Credit cannot offset the NIIT!
U.S. citizens working abroad and subject to the NIIT will not be able to offset that tax with taxes incurred in the foreign country where they work, even if for those taxes credits would otherwise be allowed
The trick is that the foreign taxes are allowed as a credit against the tax imposed by the chapter 1 of the Internal Revenue Code which includes sections 1 through 1400. However, the NIIT is imposed by section 1411, which is not in chapter 1 and as such cannot be offset by foreign taxes.
If you take foreign income taxes as an income tax deduction (versus a tax credit), some (or all) of the deduction amount may deducted against Net Investment Income which can at least lower your taxation base.