Planning for the 3.8% Net Investment Income Tax
Starting with the 2013 tax year, high-income taxpayers face a 3.8% tax on their net investment income (the net investment income tax or NIIT) that is imposed in addition to regular income tax. Here's an overview of the new tax and steps you can take to reduce its impact.
The NIIT will apply to you only if your modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, $200,000 for unmarried taxpayers and heads of household. The amount actually subject to the tax is the lesser of your net investment income or the amount by which your MAGI exceeds the threshold ($250,000, $200,000, or $125,000) that applies to you.
Your net investment income includes your interest, dividend, annuity, royalty, and rental income, unless those items were derived in the ordinary course of an active trade or business. Taxable net gain from dispositions of property, other than property held in an active trade or business, is also subject to the tax.
In addition, other gross income from a trade or business that is a passive activity is subject to the NIIT, as is income from a business of trading in financial instruments or commodities.
There are many types of income that are exempt from the NIIT. Any item that is excluded from income for income tax purposes is likewise excluded from the NIIT. This means that tax -exempt interest and the excluded gain from the sale of your main home aren't subject to the tax.
Distributions from qualified retirement plans, including individual retirement accounts (IRAs) and Roth IRAs, aren't subject to the NIIT. Wages and self-employment income aren't subject to the NIIT, though they may be subject to a different Medicare surtax.
It's important to remember the NIIT applies only if you have net investment income and your MAGI exceeds the applicable thresholds discussed above. So, consideration should be given to the following strategies that may minimize net investment income:
Investment choices. If your income is high enough to trigger the NIIT regularly, shifting some income investments to tax -exempt bonds could result in less exposure to the NIIT. Tax -exempt bonds both lower your MAGI and avoid the NIIT.
Dividend-paying stocks will be taxed more heavily as a result of the NIIT. The maximum income tax rate on qualified dividends is 20%, but the rate becomes 23.8% with addition of the NIIT.
As a result, you may want to consider rebalancing your investment portfolio to emphasize growth stocks over dividend-paying stocks. While the capital gain from these investments will be included in net investment income, there are two potential benefits: (1) the tax will be deferred because the capital gain won't be subject to the NIIT until the stock is sold and (2) capital gains can be offset by capital losses, which isn't the case with dividends.
Qualified plans . Because distributions from qualified retirement plans are exempt from the NIIT, upper-income taxpayers with some control over their situations (i.e., small business owners), might want to make greater use of qualified plans. For example, creating a traditional defined benefit pension plan will increase tax deductions now and generate future income that may be exempt from the NIIT.
Charitable donations. Consider donating appreciated securities to charity rather than donating cash. This will avoid capital gains tax on the built-in gain of the security and avoid the 3.8% NIIT on that gain, while generating an income tax charitable deduction equal to the fair market value of the security. You could then use the cash you would have otherwise donated and repurchase the security to achieve a step-up in basis.
Passive activities. As mentioned above, income from passive activities is generally included in net investment income and is subject to the NIIT. If you can increase level of participation in an activity so that the business income becomes non-passive, the tax can be avoided.
In determining whether an activity is active or passive, there are rules governing what constitutes an “activity” and how different activities are aggregated. The general passive activity rules give some leeway to group trades or businesses or rental activities together to satisfy the material participation standards and avoid characterization of activities as passive.
In general, a taxpayer's initial grouping of activities can't be changed unless the prior grouping was clearly inappropriate or there is a material change in facts and circumstances. However, because the activity groupings now have an effect on the NIIT, IRS will allow you to make a “fresh start” by regrouping activities.
You can make the regrouping election on your 2013 return if you are subject to the NIIT in 2013. If you don't make the election for 2013, you may make it for the first tax year after 2013 that you are subject to the NIIT. Only one regrouping is permitted, and it is effective for all later years.
The regrouping privilege can be used to treat net income from the newly combined group as non-passive business income and avoid the NIIT on that income. Please keep in mind, however, that this can have the negative effect of transforming passive income that can be offset with passive losses into non-passive income that can't be offset by passive losses.
Rental income. Rental income that isn't derived from a trade or business is subject to the NIIT. If the rental income is derived from a trade or business, it will usually be considered passive income, and therefore also subject to the NIIT.
Still, there are avenues for avoiding the NIIT on rental income. If you properly group a rental activity together with a trade or business activity, and the grouped activity isn't passive, the rental income won't be subject to the NIIT.
If you qualify as a “real estate professional,” as defined under the passive activity rules, and you materially participate in your rental real estate activities, those activities aren't considered passive. If the rental income is derived in the ordinary course of a trade or business, it won't be subject to the NIIT. IRS regulations include safe harbors for ensuring that you qualify for that exemption.
Finally, in the case of a “self-rental,” where you rent out your property for use in a trade or business activity in which you materially participate, the rental income is treated as non-passive both for passive activity and NIIT purposes. As a result, that income won't be subject to the NIIT.
As you can see, the NIIT may have a significant effect on your tax picture going forward. Anyone who might be subject to the tax should include it in their tax planning . I would be happy to meet with you to discuss tax-planning strategies so that the impact of the NIIT can be minimized.
© 2014 Thomson Reuters/Tax & Accounting. All Rights Reserved.
The NIIT will apply to you only if your modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, $200,000 for unmarried taxpayers and heads of household. The amount actually subject to the tax is the lesser of your net investment income or the amount by which your MAGI exceeds the threshold ($250,000, $200,000, or $125,000) that applies to you.
Your net investment income includes your interest, dividend, annuity, royalty, and rental income, unless those items were derived in the ordinary course of an active trade or business. Taxable net gain from dispositions of property, other than property held in an active trade or business, is also subject to the tax.
In addition, other gross income from a trade or business that is a passive activity is subject to the NIIT, as is income from a business of trading in financial instruments or commodities.
There are many types of income that are exempt from the NIIT. Any item that is excluded from income for income tax purposes is likewise excluded from the NIIT. This means that tax -exempt interest and the excluded gain from the sale of your main home aren't subject to the tax.
Distributions from qualified retirement plans, including individual retirement accounts (IRAs) and Roth IRAs, aren't subject to the NIIT. Wages and self-employment income aren't subject to the NIIT, though they may be subject to a different Medicare surtax.
It's important to remember the NIIT applies only if you have net investment income and your MAGI exceeds the applicable thresholds discussed above. So, consideration should be given to the following strategies that may minimize net investment income:
Investment choices. If your income is high enough to trigger the NIIT regularly, shifting some income investments to tax -exempt bonds could result in less exposure to the NIIT. Tax -exempt bonds both lower your MAGI and avoid the NIIT.
Dividend-paying stocks will be taxed more heavily as a result of the NIIT. The maximum income tax rate on qualified dividends is 20%, but the rate becomes 23.8% with addition of the NIIT.
As a result, you may want to consider rebalancing your investment portfolio to emphasize growth stocks over dividend-paying stocks. While the capital gain from these investments will be included in net investment income, there are two potential benefits: (1) the tax will be deferred because the capital gain won't be subject to the NIIT until the stock is sold and (2) capital gains can be offset by capital losses, which isn't the case with dividends.
Qualified plans . Because distributions from qualified retirement plans are exempt from the NIIT, upper-income taxpayers with some control over their situations (i.e., small business owners), might want to make greater use of qualified plans. For example, creating a traditional defined benefit pension plan will increase tax deductions now and generate future income that may be exempt from the NIIT.
Charitable donations. Consider donating appreciated securities to charity rather than donating cash. This will avoid capital gains tax on the built-in gain of the security and avoid the 3.8% NIIT on that gain, while generating an income tax charitable deduction equal to the fair market value of the security. You could then use the cash you would have otherwise donated and repurchase the security to achieve a step-up in basis.
Passive activities. As mentioned above, income from passive activities is generally included in net investment income and is subject to the NIIT. If you can increase level of participation in an activity so that the business income becomes non-passive, the tax can be avoided.
In determining whether an activity is active or passive, there are rules governing what constitutes an “activity” and how different activities are aggregated. The general passive activity rules give some leeway to group trades or businesses or rental activities together to satisfy the material participation standards and avoid characterization of activities as passive.
In general, a taxpayer's initial grouping of activities can't be changed unless the prior grouping was clearly inappropriate or there is a material change in facts and circumstances. However, because the activity groupings now have an effect on the NIIT, IRS will allow you to make a “fresh start” by regrouping activities.
You can make the regrouping election on your 2013 return if you are subject to the NIIT in 2013. If you don't make the election for 2013, you may make it for the first tax year after 2013 that you are subject to the NIIT. Only one regrouping is permitted, and it is effective for all later years.
The regrouping privilege can be used to treat net income from the newly combined group as non-passive business income and avoid the NIIT on that income. Please keep in mind, however, that this can have the negative effect of transforming passive income that can be offset with passive losses into non-passive income that can't be offset by passive losses.
Rental income. Rental income that isn't derived from a trade or business is subject to the NIIT. If the rental income is derived from a trade or business, it will usually be considered passive income, and therefore also subject to the NIIT.
Still, there are avenues for avoiding the NIIT on rental income. If you properly group a rental activity together with a trade or business activity, and the grouped activity isn't passive, the rental income won't be subject to the NIIT.
If you qualify as a “real estate professional,” as defined under the passive activity rules, and you materially participate in your rental real estate activities, those activities aren't considered passive. If the rental income is derived in the ordinary course of a trade or business, it won't be subject to the NIIT. IRS regulations include safe harbors for ensuring that you qualify for that exemption.
Finally, in the case of a “self-rental,” where you rent out your property for use in a trade or business activity in which you materially participate, the rental income is treated as non-passive both for passive activity and NIIT purposes. As a result, that income won't be subject to the NIIT.
As you can see, the NIIT may have a significant effect on your tax picture going forward. Anyone who might be subject to the tax should include it in their tax planning . I would be happy to meet with you to discuss tax-planning strategies so that the impact of the NIIT can be minimized.
© 2014 Thomson Reuters/Tax & Accounting. All Rights Reserved.