Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at a question about whether/how to deduct investment expenses - including investment management fees - against net investment income for the purposes of calculating a client's exposure to the new 3.8% Medicare surtax.
Comment/Question: In your presentation on the 3.8% Medicare tax on portfolio income, you state that net investment income can be reduced by investment expenses, including investment management fees. But how does this work? Are 100% of investment management fees used to offset net investment income, or is it only a portion of the fees allowed after the 2%-of-AGI limitation?
Last December, the IRS issued proposed regulations on the 3.8% Medicare surtax on net investment income, and addressed a number of points of confusion regarding how to properly calculate and allocate deductions against the new tax. The general guidance indicated that any limitations on gains, losses, and deductions that apply for other parts of the tax code will apply for the purposes of the new IRC Section 1411 Medicare tax as well.
For instance, if gains are recognized on an installment sale basis over multiple years for regular tax purposes, those gains will be allocated year by year for the Medicare tax purpose as well; similarly, if gains are deferred through a 1031 like-kind exchange of real estate or a 1035 like-kind exchange of annuities, the gain is deferred and not (currently) subject to the 3.8% Medicare tax either. In the case of losses and deductions, the rule again is that whatever applies for regular tax purposes applies for the Medicare tax; thus, the limits on investment interest expenses still apply, as do the limits on passive activity losses, and the restrictions on long-term capital losses that must be netted against capital gains.
In the case of investment expenses like investment management fees, though, the process is a bit more complex. The rules do specify that the 2%-of-AGI threshold continues to apply against investment management fees - as it otherwise would - but the calculation is complicated by the fact that there are other miscellaneous itemized deductions that are not valid deductions against investment income for the 3.8% Medicare tax, and in 2013 the phaseout of itemized deductions for high-income earners also returned and must also be applied against these investment deductions.
Proposed Regulations 1.1411-4(f)(3)(i)(B) and (f)(3)(ii) provide the guidance in how this should be done. First and foremost, investment expenses are only deductible to the extent that they otherwise exceed the 2%-of-AGI threshold. Thus, for instance, if a single client had $1M of AGI and spent $50,000 on investment management fees, the deduction for both regular and 3.8% Medicare tax purposes would be limited to $30,000 (the amount above the 2%-of-$1M threshold).
If the grouping of miscellaneous itemized deductions includes both investment and non-investment deductions, the calculation is more complex, as the 2%-of-AGI threshold must be allocated pro-rata between the investment and non-investment expenses. For instance, if the preceding client example also included $10,000 of unreimbursed employee business expenses, the total miscellaneous itemized deductions would be $60k, of which $40k (above the 2%-of-$1M AGI threshold) would be deductible. Since $50k / $60k = 83.3% of the deductions are investment-related, then 83.3% x $40k of the actually deductible investment expenses are treated as deductible for the Medicare tax. Thus, the investor would be able to deduct 83.3% x $40k = $33.3k of investment management fees against investment income for the Medicare tax (the other $6.7k of deductions are assumed to be the job expenses).
Of course, the caveat is that in 2013, this client would also be subject to the return of the high-income phaseout of itemized deductions under the American Taxpayer Relief Act, which will further reduce his/her deductible expenses, and the Proposed Regulations require that a portion of the phaseout be allocated to the investment expenses as well. For instance, assume the preceding individual also had $70k in state income tax deductions and $30k of mortgage deductions, and given $1M of AGI is $750k over the line for the individual phaseout, reducing deductions by $750k x 3% = $22,500. Given that total deductions are $70k (state income taxes) +$30k (mortgage deductions) + $40k (all miscellaneous deductions above 2%-of-AGI floor) = $140k, then the phaseout eliminates $22,500 / $140k = 16.07% of all deductions. Accordingly, the $33.3k portion of investment expenses allocable to net investment income would be further reduced by 16.07% to $27,976, and that would be the final amount the client can claim as a deduction against net investment income for the purposes of the 3.8% Medicare tax.
Fortunately, there will be IRS forms that apply to make this simpler to calculate when the time comes (though they haven't been issued yet), but the basic gist is that investment management fees are deductible for purposes of the 3.8% Medicare tax on net investment income, but they're subject to the 2%-of-AGI floor, and allocated pro-rata if there are multiple miscellaneous itemized deductions, and any high-income phaseout of itemized deductions is further allocated pro-rata against the deduction.
Notably, these rules would apply for both investment management fees paid on behalf of taxable accounts, and also investment management fees for retirement accounts if those fees are paid with outside dollars (if deducted from the account, they're already pre-tax by definition of having come from the account without being treated as a distribution).
I hope that helps a little!