Taxpayers facing liability under the new §1411 net investment income tax (NIIT) that takes effect for tax years after 2012 have been asking whether a prior year capital loss carryover may be netted against current year capital gains in determining net investment income. Long-awaited proposed regulations would provide that current year capital gains generally may be reduced by prior year capital losses.

The NIIT equals 3.8% of certain net investment income, including capital gains, of individuals, estates and trusts that have income above statutory threshold amounts. Examples of capital gains that would be subject to the tax are gains from the sale of stocks, bonds, and mutual funds, capital gain distributions from mutual funds, and gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).

The proposed regulations would provide that the amount of net gain included in net investment income may not be less than zero. Deductions not taken into account for NIIT purposes because they would reduce net investment income below zero may only be taken into account in another tax year to the extent allowed for income tax purposes (such as a capital loss carryforward under §1212).

Suppose, for example, that in Year 1 Taxpayer has a net capital loss for the year of $30,000 after selling P stock for a $40,000 loss and selling Q stock for a $10,000 gain. For income tax purposes, under §1211(b), Taxpayer may use $3,000 of the net capital loss against other income in Year 1. Under §1212(b)(1), the remaining $27,000 is a capital loss carryover.

Taxpayer's Year 1 net gain for NIIT purposes is $0, determined by reducing the gain of $10,000 on the sale of Q stock by the $40,000 loss on the P stock. However, because net gain may not be less than zero, Taxpayer may not reduce net investment income by the $3,000 allowed for income tax purposes under §1211(b).

Suppose further that in Year 2, Taxpayer has a capital gain of $30,000 on the sale of Y stock. For income tax purposes, Taxpayer may reduce the $30,000 gain by the Year 1 $27,000 capital loss carryover. For purposes of determining Taxpayer's Year 2 NIIT net gain, Taxpayer's $30,000 Year 2 gain may also be reduced by the $27,000 capital loss carryover. Therefore, in Year 2, Taxpayer has $3,000 of net gain.

Peter E. Burt, J.D., LL.M.

Federal Tax Law Editor