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Planning to avoid or minimize the 3.8% net investment income tax

BY REED TINSLEY, CPA, CVA, CFP, CHBC

As you know, the new 3.8% Medicare tax on net investment income, which we I call the NIIT, is effective for tax years beginning on or after 1/1/13. In this article, I will cover some planning ideas that may allow individual taxpayers to avoid or minimize the NIIT. Since year-end is not too far away, you can include these ideas with your other yearend tax planning strategies.

Net Investment Income Tax (NIIT) basics

Before jumping into the planning strategies, let’s first rehash the basics. An individual is only hit with the NIIT when his or her Modified Adjusted Gross Income (MAGI) exceeds $200,000 for an unmarried taxpayer, $250,000 for a married joint-filing couple or a qualifying widow or widower, or $125,000 for married filing separate couples. The amount actually subject to the NIIT is the lesser of: (1) net investment income or (2) the amount by which MAGI exceeds the applicable threshold. For this purpose, MAGI is AGI plus certain excluded foreignsource income of U.S. citizens and residents living abroad net of certain deductions and exclusions.

The following types of income and gain (net of related deductions) are generally included in the definition of net investment income and, thus, potentially exposed to the NIIT:

• Net gain from selling assets held for investment-including gains from selling investment real estate and the taxable portion of gain from selling a personal residence. • Capital gain distributions from mutual funds.

• Gross income from interest (not including tax-free interest such as municipal bond interest), dividends, royalties, and annuities.

• Gross income and net gain from passive business activities (meaning business activities in which the taxpayer does not materially participate) and gross income from rents.

• Net gain from selling partnership and S corporation interests held for investment.

• Gross income and gain from the business of trading in financial instruments or commodities (whether the taxpayer materially participates or not).

Setting the proper target for NIIT planning strategies

As explained earlier, the NIIT for individual taxpayers hits the lesser of: (1) net investment income or (2) the amount by which MAGI exceeds the applicable threshold. Therefore, planning strategies will be effective only if they target the applicable exposure point.

If net investment income is the lower number (i.e., net investment income is less than MAGI), your NIIT exposure will mainly depend on your net investment income. So planning should focus first on strategies that reduce net investment income. Of course, some of these strategies will also reduce AGI.

If MAGI is the lower number, your NIIT exposure will mainly depend on your AGI. So planning should focus first on strategies that will reduce AGI. Of course, here too, some of these strategies will also reduce net investment income.

Specific strategies to reduce this year’s net investment income

Here are few ideas to reduce net investment income:

• Selling loser securities held in taxable brokerage firm accounts to offset earlier gains from such accounts. (This will also reduce AGI.)

• Gifting soon-to-be-sold appreciated securities to children and letting them sell them to avoid including the gains on the parent’s return. (This will also reduce the parent’s AGI.) But beware of the Kiddie Tax, which can potentially cause children under age 24 to pay taxes at their parent’s higher rates. However, as long as the investment income is reported on the child’s return (i.e., the parents don’t elect to include it on their return), it won’t be subject to the NIIT unless the child’s MAGI exceeds his or her applicable threshold.

• Utilizing an installment sale to spread a big investment gain over several years. (This will also reduce AGI.)

• Instead of cash, gifting appreciated securities to IRS-approved charities. That way, the gains won’t be included on the donor’s return. (This will also reduce the donor’s AGI.)

Conclusion

These are just a few ideas for reducing or avoiding the NIIT – there are others. Some ideas take time to implement so start discussing this issue with your tax advisor now if you think you might be subject to this new tax this year. ▼