In “Capital Gains Tax Gets More Complicated,” we wrote:

Should your modified adjusted gross income (MAGI) exceed $250,000 (for married filing jointly) or $200,000 (for single filing), you owe an additional 3.8% beyond the tax rate of 15% thanks to the Affordable Care Act (ACA). This created the new rate of 18.8%.

This 3.8% surtax (called the Net Investment Income Tax or NIIT) also applies if Net Investment Income exceeds the same thresholds. But since MAGI is almost always bigger than Net Investment Income, the secondary test of Net Investment Income will rarely matter.

MAGI is a common tax term to denote the resulting value of your adjusted gross income (AGI) with some items added back in. However, each use of MAGI may have different variables added back. In this case, MAGI is your AGI from your 1040 plus any foreign earned income you excluded from gross income. That foreign earned income can be reduced by any deductions or exclusions that you were unable to claim because they were related to that excluded foreign income.

Unless you have foreign earned income, NIIT’s MAGI calculation will be no different than AGI. Thus, unless your AGI exceeds the NIIT threshold, the surtax will not be applied.

The secondary test of Net Investment Income is just a subset of the income sources included in AGI with different allowable deductions. For most people, the Net Investment Income calculation will be the sum of taxable interest, all dividends, capital gains, and rental income reduced by deductible investment expenses. This differs from AGI mostly because it excludes earned income and differs from MAGI by allowing for more deductions via investment expenses.

As a result, Net Investment Income will almost always be smaller than both AGI and MAGI.   Thus, the real thing to watch is your AGI. This is especially true since the only modification for AGI in the MAGI calculation is foreign earned income, which few people have.

Qualified dividends and capital gains are counted for AGI even though they will be taxed lower than other income, and sometimes not at all. That means you should pay attention to how much capital gains you realize, and if you have a financial advisor, to be in contact with them. Also, despite the fact that in the end, you may owe little or no tax due to exemptions, itemized deductions, and tax credits, all of that happens after AGI is calculated. As a result, none of that will help in determining whether or not you will have to pay the surtax.

There are a few expenses that offset income before AGI is calculated. Capital losses and business losses (up to $3,000 each) can reduce income, as can contributing to a health savings account or IRA, alimony paid, interest paid on student loans, the tuition and fees deduction, expenses incurred while moving to a new home, and a host of things if you are self-employed (half of self-employment taxes owed, contributions to a SEP, and the expenses of health insurance). Carefully documenting any of these expenses and taking advantage of them on your taxes will help reduce the chances of having to pay the surtax. Of course, waiting to realize capital gains will help as well.

While this surtax is ostensibly to make taxation of investments “more fair,” it will tax far more people than it intends. Anyone who sells a moderately-priced home may run afoul of the surtax, because however much profit it brings beyond $250,000 is taxed as capital gains, and thus is included in AGI. Anybody selling a highly-appreciated house can be taxed like a “greedy investor” completely regardless of their actual regular income or lifestyle, which seems unfair. At any rate, this capital gains surtax is something to watch when considering selling your home.

Further, this surtax carries a substantial marriage penalty. The threshold for the tax is only $50,000 lower for Single filers than Married filers with no relief in filing separately. Two unmarried individuals each making $125,000 will be just fine, but if they are married, their incomes combine to $250,000 and they have to pay 3.8% extra tax on capital gains.

In conclusion, despite the fact that there are two tests that can qualify someone for the 3.8% capital gains surtax, raw AGI is really the only important factor. Married taxpayers should pay special attention to the thresholds, as it is far easier for them to qualify for the surtax than Single ones. Also keep the thresholds in mind when considering when to sell a home and especially when to realize capital gains. Realizing capital losses and carefully considering above-the-line tax deductions which reduce AGI will give some breathing room if you are close to the threshold. And if you find yourself in the unfortunate position of having to pay the surtax, that is done by filing Form 8960 with your 1040.

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