Form 8960 IRS Filing: What You Need to Know About Common Errors

Filing taxes can be complicated, and Form 8960 adds another layer for certain taxpayers. This form calculates the Net Investment Income Tax (NIIT), an additional 3.8% tax on specific types of income. Errors in completing it can lead to miscalculations, IRS scrutiny, or unexpected tax liabilities.

Understanding common mistakes when filing Form 8960 can help avoid penalties and ensure compliance.

Who Must File This Form

Form 8960 applies to individuals, estates, and trusts that exceed specific income thresholds. For individuals, the tax applies when modified adjusted gross income (MAGI) surpasses $200,000 for single filers, $250,000 for married couples filing jointly, and $125,000 for married individuals filing separately. Estates and trusts are subject to the tax if their income exceeds the highest trust tax bracket, which is $15,200 for 2024.

A one-time financial event, such as selling a business or receiving an inheritance that generates investment income, can also trigger the tax. Even those who do not typically owe this tax should review their income sources annually.

Certain types of income are excluded, including wages, Social Security benefits, and distributions from qualified retirement plans. However, taxpayers with both earned and investment income should be aware that exceeding the MAGI threshold by even a small amount can result in liability for the additional tax.

Income Subject to the Additional Tax

The NIIT applies to unearned income, which includes investment earnings rather than wages or self-employment income. Understanding which income sources are subject to this tax ensures accurate reporting and prevents miscalculations.

Interest

Interest income subject to the NIIT includes earnings from savings accounts, certificates of deposit (CDs), corporate bonds, and certain U.S. Treasury securities. However, tax-exempt interest, such as that from municipal bonds, is not included.

For example, if a taxpayer earns $10,000 in interest from a corporate bond and their MAGI exceeds the applicable threshold, this amount is subject to the 3.8% tax, resulting in an additional $380 ($10,000 × 3.8%). If the interest were from a municipal bond, it would not be included in the NIIT calculation.

Taxpayers should review Form 1099-INT, which financial institutions issue to report interest income. Ensuring that only taxable interest is included on Form 8960 can prevent overpayment. Those with significant interest income may consider tax-efficient investment strategies, such as shifting to municipal bonds, to reduce their NIIT liability.

Dividends

Dividend income, including both qualified and ordinary dividends, is subject to the NIIT. Qualified dividends benefit from lower capital gains tax rates, while ordinary dividends are taxed as regular income. Regardless of classification, both are included in the NIIT calculation if the taxpayer’s MAGI exceeds the threshold.

For instance, if an investor receives $15,000 in qualified dividends and $5,000 in ordinary dividends, the total $20,000 is subject to the 3.8% tax if they meet the income requirement. This results in an additional tax of $760 ($20,000 × 3.8%).

Taxpayers should carefully review Form 1099-DIV, which reports dividend income. Errors in classification can lead to incorrect tax calculations. Those with substantial dividend income may explore tax-efficient investment options, such as holding dividend-paying stocks in tax-advantaged accounts like IRAs or 401(k)s, to minimize exposure to the NIIT.

Capital Gains

Capital gains, both short-term and long-term, are included in the NIIT calculation. Short-term gains, from assets held for one year or less, are taxed at ordinary income rates, while long-term gains benefit from lower capital gains tax rates. If a taxpayer’s MAGI exceeds the threshold, these gains are subject to the additional 3.8% tax.

For example, if a taxpayer sells stock for a $50,000 gain and their MAGI is above the threshold, they owe an additional $1,900 ($50,000 × 3.8%) in NIIT. If the gain is long-term, they also pay the applicable capital gains tax, which could be 15% or 20%, depending on their income level.

Taxpayers should review Form 1099-B, which brokers issue to report capital gains and losses. Offsetting gains with capital losses can reduce NIIT liability. If a taxpayer has $50,000 in gains but also realizes $20,000 in losses, only the net $30,000 is subject to the tax, reducing the NIIT to $1,140 ($30,000 × 3.8%).

Rental Income

Rental income from investment properties is generally subject to the NIIT unless the taxpayer qualifies as a real estate professional under IRS rules. Passive rental income, which applies to most landlords, is included in the calculation. However, if a taxpayer materially participates in real estate activities, they may be able to exclude this income from the NIIT.

For example, if a taxpayer earns $25,000 in net rental income and their MAGI exceeds the threshold, they owe an additional $950 ($25,000 × 3.8%) in NIIT. If they actively manage the property and meet the IRS’s real estate professional criteria, this income may be exempt.

Taxpayers should review Schedule E (Supplemental Income and Loss) to ensure accurate reporting. Those with significant rental income may consider strategies such as increasing deductible expenses or restructuring their real estate activities to reduce NIIT exposure.

Deductions and Adjustments

Taxpayers subject to the NIIT can lower their taxable investment income by claiming specific deductions. The IRS allows certain expenses directly related to earning investment income to be deducted before calculating the 3.8% tax. These deductions must be properly documented and supported by financial records.

Investment advisory fees, state and local income taxes on investment earnings, and certain legal expenses related to investment activities are deductible when calculating net investment income. For example, if a taxpayer incurs $5,000 in investment advisory fees and has $50,000 in taxable investment income, their NIIT liability is based on $45,000 instead of the full $50,000. This adjustment reduces the additional tax owed by $190 ($5,000 × 3.8%). However, general financial planning fees do not qualify for this deduction.

Depreciation and operating costs associated with rental properties can also reduce NIIT liability. If a taxpayer owns a rental property generating $30,000 in annual income but has $10,000 in allowable deductions for maintenance, property management fees, and depreciation, only the remaining $20,000 is subject to the NIIT. Proper classification of these expenses on Schedule E ensures accurate reporting and prevents overpayment.

Trusts and estates face additional complexities when calculating deductions. Administrative expenses incurred in managing a trust’s investments, such as trustee fees and accounting costs, can be deducted before determining net investment income. However, distributions to beneficiaries reduce the amount of income subject to the NIIT at the trust level, potentially shifting the tax burden to individuals who may fall below the income threshold. Strategic distribution planning can help minimize the overall NIIT impact.

How the IRS Verifies Accuracy

The IRS uses automated systems and manual reviews to ensure Form 8960 is completed correctly. Automated systems cross-check reported investment income against third-party documents such as Forms 1099-INT, 1099-DIV, and 1099-B. Any discrepancies can trigger notices or further examination.

Beyond automated matching, the IRS uses statistical analysis to identify patterns of underreporting. Taxpayers with unusually low net investment income relative to total income may be flagged for additional scrutiny. High-income individuals and trusts are more likely to be examined. If a return is selected for review, the IRS may request supporting documentation, such as brokerage statements, expense records, and tax basis calculations for capital gains.

Possible Consequences of Filing Errors

Mistakes on Form 8960 can lead to additional tax liabilities, penalties, and audits. Even minor miscalculations can result in adjustments that increase the amount owed.

If the IRS detects an underpayment, the taxpayer must pay the additional tax owed, plus interest. Interest accrues from the original due date of the return until the balance is paid. In cases of negligence or substantial understatement of tax, penalties may apply. A substantial understatement occurs when the reported tax liability is understated by the greater of 10% of the correct tax or $5,000 for individuals. The penalty is typically 20% of the underpaid amount.

More serious cases involving intentional misreporting can lead to civil fraud penalties of 75% of the underpaid tax. In rare cases, criminal charges may be pursued. Ensuring accurate reporting and proper documentation can help avoid these risks. Seeking professional tax advice can also reduce the likelihood of errors and audits.