Beyond portfolio management, two areas of planning are significantly important to affluent and high-net-worth clients:  tax planning and estate planning. In this post, we will focus on taxes, and more specifically, the Net Investment Income Tax (NIIT). We will discuss what it is, who is affected, what triggers it and, most important, we will list several ways to reduce and/or eliminate it. 

The NIIT is part of the Health Care and Education Reconciliation Act of 2010, effective January 1, 2013. The NIIT tax is 3.8% on the lesser of:

a)      Net Investment Income; or

b)      The amount MAGI exceeds $250,000 (married filing jointly) or $200,000 (all others)

The purpose of the NIIT was to fund approximately 50% of the total cost of Obamacare. Initial projections from the IRS indicated this would affect about three million taxpayers. Because the thresholds are not indexed to inflation, the number of affected taxpayers is expected to rise.

What Is Included?

Net investment income includes, but is not limited to, the following:

  • Interest, dividends, and capital gains

  • Rental income (unless derived from a trade or business to which the NIIT does not apply)
  • Royalty income
  • Income from non-qualified annuities
  • Gain from the sale of a personal residence to the extent it exceeds IRS Section 121 ($250,000 single; $500,000 married filing jointly)
  • Gain from the sale of investment real estate, including a second home that is not a primary residence
  • Income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer per IRS Section 469 (i.e. passive activity losses and credits)
  • Gain from the sale of interests in partnerships and S corporations to the extent the partner or shareholder was a passive owner.

What is Modified Adjusted Gross Income (MAGI)?

For the majority of those affected, MAGI will be the same as AGI. Specifically, MAGI is AGI plus:

  • The difference between amounts excluded from gross income under section 911(a)(1), and

  • The amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) for amounts described in section 911(a)(1).

While the full explanation is beyond the scope of this post, IRS Section 911(a)(1) is foreign income earned abroad and Section 911(d)(6) involves the denial of double benefits. In short, foreign income may be double taxed. 

How Is the NIIT Calculated?

To demonstrate how the NIIT is calculated, let’s assume we have a married couple with a MAGI of $425,000 and net investment income of $150,000. Their NIIT is the lesser of the following:

  • Net Investment Income x NIIT Tax Rate or $150,000 x 3.8% = $5,700
  • MAGI – Threshold x NIIT Tax Rate or $425,000 – $250,000 = $175,000 x 3.8% = $6,650

Their NIIT tax would be $5,700, since this is the lesser of the two methods. 

How to Minimize the NIIT

As is the case with many tax laws, the government will project a revenue stream, but fail to consider the strategies taxpayers will employ to avoid or reduce their tax burden. The underlying idea is to reduce your MAGI. Here are a few ways to minimize or avoid the NIIT.

  1. Maximize contributions to your company’s retirement plan

  2. Sell securities at a loss to offset capital gains
  3. Gift appreciated securities to charity rather than cash donations. You will get a charitable deduction and avoid the capital gains tax.
  4. Become more active in passive activities. Income from a non-passive activity is not subject to the NIIT. This may require over 500 hours of personal involvement or as low as 100 hours in certain situations (ask a qualified tax professional).
  5. On gain subject to the NIIT, spread the gain out over several years using an installment sale.
  6. Utilize a tax-free IRS Section 1031 like-kind exchange where applicable (e.g., investment real estate).
  7. Self-Employed Business Owners: Defer business income into the following year and accelerate business deductions into the current year.

There are additional methods to minimize or eliminate the NIIT. The NIIT is one more tax in a long line of new taxes. I suspect we will see several new taxes moving forward as the national debt continues to expand. As a result, the importance of tax planning should continue to rise for several years.

Until next time, thanks for reading and have a great week!