Avoiding The Net Investment Income Tax

The Patient Protection and Affordable Care Act not only brought us Obamacare, but also the web Investment Income Tax or NIIT. This new tax, which really is a Medicare surtax, is a 3.8% taxes on numerous kinds of investment income received by certain individuals, trusts, and estates. Who does it apply to? 125,000 for married filing separately) must pay the 3.8% NIIT on the smaller of (1) online-investment income, as described later, or (2) the amount where MAGI exceeds the suitable threshold. The NIIT will not apply to corporations, limited liability companies taxed as companies, or nonresident aliens.

What is Net Investment Income? For the purposes of NIIT, net investment income (NII) is defined as the following items. Interest, dividends, annuities, royalties, and rents less properly allocated deductions. Gross income from a small business or trade that is clearly a passive activity. Gross income from a small business or trade of trading in financial instruments or goods. Net gain from the disposition of nonbusiness property or the disposition of property held in a trade or business that is a passive activity. Any income, gain, or reduction attributable to an investment of working capital. Generally, NII only includes amounts that are contained in a regular taxable income for the year. Therefore, items such as tax-exempt interest aren’t included in NII.

Investment interest expense to the extent it is allowed for regular taxes purposes. Property fees on investment property. State and local income taxes paid on investment income. Investment expenditures more than 2% of AGI that are allocable to investment income. However, if the taxpayer’s overall itemized deductions are limited, credited to exceeding certain income thresholds, then your above deductions are reduced as well.

20,000 of tax-exempt interest income. 70,000 NII). The 20,000 tax-exempt interest income is not included in MAGI nor in NII for purposes of the NIIT. Approaches for coping with the NIIT find ways to either reduce your MAGI typically, NII, or both. Here are a few suggestions ranging from rather simple to complex. Sell securities held in taxable brokerage accounts that will create losses to help offset any gains in the account during the year. This can help reduce both NII and MAGI.

Consider donating appreciated securities to IRS approved charities. Any gain that could have been included on your tax return is excluded, reducing both NII and MAGI thus, and you will still get a charitable deduction predicated on the fair market value of the securities donated. Maximize deductible contributions to tax-favored pension accounts, such as a 401(k). This won’t reduce NII but will certainly reduce MAGI which might be beneficial to taxpayers that are near to the income threshold for the NIIT. Consider investing additional money in tax-exempt bonds or in growth stocks, which typically pay smaller dividends. Both options shall reduce both NII and MAGI while you own the shares.

When the growth stocks can be purchased, the negative impact of any benefits can be offset by selling stocks that have declined in value. Consider buying tax-deferred annuity products. The wages from tax-deferred annuities are not taxed until these are withdrawn. Plus, you can organize to receive payments in pension when you could expect your income to be less than it is now. This strategy helps reduce NII presently because the cash flow to grow tax-free. If you are considering selling an investment property or activity, you may want to consider an installment sale where you receive the sales proceeds over one or more years.

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In an installment sale, instead of recognizing the whole gain in the year of sale, the gain is only known in the proportion of sales proceeds received during the calendar year. This will reduce both NII and MAGI in the entire year of sale and the spread of gain over many years may lessen or eliminate the amount of gain at the mercy of the NIIT.

If you have any investments in partnerships or S corporations which have been treated as passive activities, year to reexamine your level of activity and involvement in those activities it could be a good. If you materially participate, which is normally thought as regular, continuous, and substantial involvement in the activity’s operations, then your activity would no longer be passive; and, therefore, no more at the mercy of the NIIT.

If you find that your partnership and S-company investments are still passive after reexamine your participation, you might have another option. One or more business or rental activities can be grouped together to be treated as a single activity if the actions constitute a proper economic unit. Now you can look at your participation in this grouped activity to determine if it is passive.

Bart is the owner of a relationship that participates in two activities, Y and X, which he has grouped properly. He participates in X to get more than 500 hours during the year and it is treated as materially participating in the activity. During the year Bart only participates in Y for 50 hours. But for the grouping of the two activities together, he would not be treated as materially participating in Y. But, because of the grouping, Bart is treated as materially participating in both activities. So, neither X nor Y is a passive activity. Therefore, the 3.8% NIIT does not connect with either activity.