Net Investment Income Tax and the Impact on U.S. Citizens in Canada

by Dec 22, 2023Tax Filing Requirements, Tax Planning

What is the Net Investment Income Tax (NIIT) and when was it introduced?

The Net Investment Income Tax (NIIT) is a surtax that the IRS applies in addition to regular income taxes. It applies to U.S. taxpayers with higher incomes who have certain types of passive income. First implemented on January 1, 2013, the Net Investment Income Tax (NIIT) was introduced as part of the Patient Protection and Affordable Care Act (often referred to as Obamacare) to help pay for the expansion of Medicare and U.S. health care reforms.

How much is the NIIT tax rate?

The NIIT is an additional 3.8% surtax on certain types of investment income.

To understand the NIIT better, it is essential to review what kind of income falls under the definition of Net Investment Income. The NIIT is defined in Section 1411 of the Internal Revenue Code (IRC). Section 1411 outlines the rules and provisions related to the imposition of the NIIT on certain types of net investment income.

The most common examples of Net Investment Income are passive income categories such as the following:

  • interest income
  • dividend income
  • capital gains
  • rent and royalty income
  • non-qualified annuity income
  • passive business income in which the taxpayer does not materially participate.

It is worth nothing that Subpart F income from Controlled Foreign Corporations (CFCs) is not subject to the NIIT, unless an individual elects to apply the NIIT to such income. Distributions of investment income from CFCs may be subject to NIIT.

It is important to note that certain types of income are excluded from Net Investment Income such as wages, self-employment income, social security benefits, tax-exempt interest and distributions from retirement plans.

Understanding the inclusions and exclusions of income for NIIT purposes is crucial for calculating the additional 3.8% tax. Since the calculation isn’t straightforward, it is recommended to consult with a cross-border tax professional to understand your exposure.

How much are the NIIT income thresholds?

It is important to note that the 3.8% NIIT only applies to taxpayers with total income exceeding certain income thresholds reported on a U.S. income tax return depending on a taxpayer’s filing category: the NIIT applies only if an individual’s modified adjusted gross income (MAGI) exceeds $250,000 USD for married couples filing jointly, $125,000 for married persons filing separately, or $200,000 for single or head of household filers.

Calculating the NIIT exposure is not as simple as multiplying net investment income by 3.8%: the IRS gives some relief by applying the NIIT to the lesser of a taxpayer’s Net Investment Income itself or the amount by which the taxpayer’s MAGI exceeds the relevant income threshold.

For example, take a single taxpayer with MAGI of $250,000 USD, with $25,000 of that coming from Net Investment Income. Their total income has exceeded the $200,000 NIIT threshold for single filers by $50,000, however the amount of their Net Investment Income itself was less than that, at only $25,000. This taxpayer would then pay the 3.8% NIIT only on the $25,000 amount of the passive income itself, resulting in a NIIT exposure of $950.

Who does the NIIT apply to?

The NIIT is applicable to U.S. citizens and residents. It does not apply to non-resident aliens, including “dual status” aliens and aliens choosing to be taxed as U.S. residents.

However, there is limited guidance from the Joint Committee on Taxation or the Treasury on how this tax impacts U.S. citizens residing outside of the United States. While some major accounting firms suggest that U.S. citizen expatriates (e.g. U.S. citizens living in Canada) may have no protection from the NIIT, there remains a potential for U.S. citizens living abroad to avoid the tax, depending on the eventual classification of this tax.

Why is the NIIT crucial to understand for U.S. citizens living in Canada?

The NIIT can be crucial for U.S citizens living in Canada due to its potential impact on their tax liability. Here are some key reasons:

  1. Worldwide Income Reporting: U.S. citizens in Canada must diligently report their worldwide income, considering the nuances of both tax systems. Failure to comply with reporting obligations can lead to penalties and complications down the line.
  2. Foreign Tax Credits: There are procedures in place that allow a U.S. citizen living abroad in a Treaty country such as Canada to receive a foreign tax credit for taxes paid on income earned in that nation. However, when it comes to the NIIT, reviewing how the U.S.-Canada tax treaty applies can become complex.
  3. Impact on Retirement Planning: Most investment portfolios and retirement accounts are structured to derive passive income that is categorized as “Net Investment Income” as mentioned above. Thus, the consequences of NIIT must be taken into account when managing investments for US citizens residing in Canada.
  4. NIIT Thresholds: When an individual’s Modified Adjusted Gross Income (MAGI) exceeds the specific thresholds mentioned above, the NIIT is triggered. U.S. citizens in Canada, who may have income from both countries, should carefully evaluate their MAGI to determine whether they meet the criteria for NIIT.

In conclusion, navigating the NIIT as a U.S. citizen in Canada requires a nuanced understanding of income types, thresholds, and applicable exclusions. It is recommended to seek professional advice by consulting cross-border tax professionals such as MCA Cross Border Advisors, who can help you optimize your U.S. and Canadian tax positions while ensuring compliance with both U.S. and Canadian tax laws.

Madhuri Bhat

Madhuri Bhat

Tax Manager

MCA Cross Border Advisors, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. The content of this presentation is for information purposes only and should not be construed as investment or financial advice. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.