The net investment income tax (NIIT) was enacted more than a decade ago. While repeal has been discussed more than once, it continues to ensnare a growing number of taxpayers. If you’re at risk for this additional tax, there may be some options to reduce your odds of owing it or the amount of your liability.
NIIT in a Nutshell
The NIIT is a 3.8% tax on net investment income to the extent that modified adjusted gross income (MAGI) exceeds:
- $200,000 for single filers,
- $250,000 for joint filers, and
- $125,000 for married taxpayers filing separately.
Unlike many other tax thresholds, those for the NIIT aren’t adjusted annually for inflation.
As a result, more and more taxpayers owe the tax. According to the Congressional Research Service, about 3.1 million taxpayers paid $16.5 billion in NIIT in 2013. In 2021, those figures had soared to 7.3 million taxpayers who paid almost $60 billion in NIIT. And it’s not just the wealthy who are affected – the NIIT can trip up anyone who receives a substantial one-time boost in income or gains.
Components of Net Investment Income
Investment income includes:
- Gains from selling investment assets (for example, stocks and other securities held in taxable brokerage accounts),
- Certain real estate gains, including the amount of capital gain from a home sale that exceeds the amount that can be excluded from taxation,
- Dividends, taxable interest, and the taxable portion of annuity payments,
- Income and gains from passive business activities in which the taxpayer doesn’t “materially participate,”
- Income from businesses involved in trading financial instruments or commodities, and
- Rents and royalties.
It doesn’t include income from interest, dividends, annuities, rents, and royalties that are earned from a non-passive business activity. It also doesn’t include tax-exempt interest or distributions from certain qualified retirement plans.
Net investment income is calculated by deducting from investment income certain expenses that can be properly allocated to it, including:
- Interest expense,
- Advisory and brokerage fees,
- Expenses related to rental and royalty income,
- Tax preparation fees, and
- State and local income taxes.
The tax rate is applied to the lesser of 1) the amount by which the MAGI exceeds the applicable threshold, or 2) net investment income.
Ways to Reduce Vulnerabilities
Your liability for the NIIT ultimately turns on the amounts of your MAGI and your net investment income. NIIT management strategies focus on reducing those two items. Here are eight common strategies to consider:
- Manage losses and gains on investments. You can harvest your tax losses for the year, selling those investments that are currently valued below their cost basis and applying the losses to offset your gains on the year. (Note that you must comply with the wash-sale rule, which prohibits the deduction of a loss when you acquire “substantially identical” investments within 30 days, before or after, the date of the sale).
- Defer capital gains on sales. You could use a Section 1031 like-kind exchange or an installment sale when you sell an investment property.
- Donate appreciated assets directly to charities. If you donate appreciated assets, rather than cash, you’ll avoid capital gains that count toward your net investment income and MAGI.
- Use qualified charitable distributions. With a qualified charitable distribution, you could donate from a retirement account with the required minimum distributions (RMDs). You can distribute up to $100,000 per year (indexed annually for inflation) after age 70½. The distribution won’t count toward your charitable deduction, but it’s removed from your taxable income and, as a bonus, is treated as an RMD.
- Invest in tax-exempt municipal and state bonds. The interest and dividends from these investments aren’t subject to the NIIT, and the interest is excluded from MAGI for NIIT purposes.
- Materially participate in business activities. Your income from a business won’t be considered passive income if you materially participate in its activities. This will exclude the business’s income from your net investment income. With the tax year rapidly drawing to a close, the easiest way to achieve material participation is to increase the amount of time you spend on the business. You’ll satisfy one of the several material participation tests if you work on the business for more than 500 hours in a year, or more than 100 hours and as much as any other person.
- Make additional retirement account contributions. MAGI is reduced by contributions to certain retirement accounts. If you’re vulnerable to the NIIT and you have extra cash on hand, it makes sense to maximize your contributions to tax-advantaged retirement accounts, including 401(k)s, SEP IRAs, and traditional IRAs.
- Minimize taxable income in the current tax year. You also might be able to defer income into the next year and accelerate deductible expenses into the current year. For instance, you could consider prepaying state and local income taxes. If you can do that for investment-related expenses, you’ll reduce the MAGI and the net investment income — for example, you could prepay property taxes on rental properties to lower your tax bill.
There’s Still Some Time
These strategies are just a few popular ideas to help you avoid or reduce your NIIT liability for 2023, but they could have unintended consequences for other tax items. We can help you determine the right steps to minimize your overall taxes.