For some high-income taxpayers writing a check to Uncle Sam was particularly painful this past tax season, and not for the most obvious reason–the 2013 increase in the top income tax rates. Instead, these folks were bitten by the new Net Investment Income Tax (NIIT), a maddeningly complicated extra 3.8% levy on certain investment income. Congress passed the tax in 2010 to help pay for the Affordable Care Act, a.k.a. ObamaCare, but it didn’t take effect until Jan. 1, 2013, and the Internal Revenue Service didn’t issue its 400 pages of final regulations governing the tax until late last November.
While those new, higher income tax rates apply only to taxable income exceeding $406,750 for a single or $457,600 for a couple (in 2014), the NIIT reaches down the income ladder, hitting those with modified adjusted gross income (MAGI) above $200,000 for a single or $250,000 for a couple. Worse, that cutoff won’t be adjusted for inflation.
What’s subject to the NIIT? Generally interest, dividends, capital gains, rental and royalty income, nonqualified annuities, businesses that are taxed on your return as “passive activities” and income from businesses involved in the trading of financial instruments or commodities.
Still, the law and final regulations leave a number of ways to reduce or avoid the NIIT, some practical, some not so much. The tax-phobic could divorce (or cancel a wedding) to avoid the NIIT’s marriage tax penalty–two singles can have income up to $400,000 (2 x $200,000) before having to pay it, compared with $250,000 for a married couple. And those with a home or citizenship outside the U.S. might flee the country and file with Uncle Sam as nonresident aliens, who aren’t subject to the NIIT. Here are ten less extreme moves (bringing the total to 12):
1. Buy munis. The NIIT isn’t levied on any interest and dividends that are normally excluded from federal income tax. At the top of the list for investors: tax-exempt state and municipal bond interest. Moreover, tax-exempt interest doesn’t count in your MAGI for NIIT, so it could help keep you below the $200,000/$250,000 threshold.
2. Give it away. Donate appreciated property to your favorite charity and you can deduct the full value of your gift but won’t have to recognize the appreciation for purposes of either the capital gains income tax or the NIIT. Give appreciated property to relatives who have income below the $200,000/$250,000 threshold and let them sell it. The “kiddie tax” means minors (and full-time students up to age 24) must pay capital gains income tax at their parents’ higher rate, but, significantly, there is no NIIT kiddie tax.
3. Lend money to your business. Interest payable as a result of a loan you’ve made is generally subject to NIIT but not if the loan is to your own business (assuming it’s a legitimate business).
4. Take an active role in your business. Passive income is a prime target for NIIT. Dividends and royalties–even from your own business–are generally considered passive and subject to NIIT. But such income isn’t subject to NIIT if it comes from a trade or business in which you materially participate (other than the trading of financial instruments or commodities). What’s material participation? Generally, if you work more than 500 hours a year in the business, if you perform most of the services in the business or if you can demonstrate a consistent work history in the business. Of course, any salary your business pays you is subject to the 2.9% Medicare payroll or self-employment tax, as well as the added 0.9% Medicare tax on employment earnings above $250,000 per couple (and also Social Security tax up to $117,000 of wages per person).
5. Rent property to your business. Usually, rental income is considered passive for income tax purposes. But under the final IRS regulations rental income you receive from property rented to your own business, even if you do not materially participate in that business, isn’t subject to NIIT. Go figure.
6. Become a Realtor. If you can qualify as a real estate professional for purposes of the federal income tax, then you can report your rental income as nonpassive, and it will be exempt from NIIT. To qualify as a pro you must spend more than 500 hours a year on real estate and more hours on real estate than on any other profession. (If you’ve got a full-time job doing something else, forget about qualifying. But a spouse who works part-time managing your jointly owned properties and holds no other job might well qualify.)
7. Swap property. Don’t qualify as a real estate pro? Then your gains on sale of real property are subject to NIIT. But if instead of selling a property you do a swap (also known as a Section 1031 like-kind exchange), any capital gain you would have recognized from a sale is deferred until the final sale of the new property received in the swap. Better yet, a 1031 defers regular capital gains tax as well as the NIIT.
8. Sell on installment. If you are selling an appreciated asset, consider whether you need the income all at once. The proceeds from installment sales are hit by the NIIT only when they’re received, not at the time of sale. With an installment sale, you can delay the tax or, even better, avoid it altogether by keeping yearly income under the $200,000/$250,000 threshold for the NIIT.
9. Sell your losers. Under the final rules, net capital losses can be used to offset gains for purposes of the NIIT so long as both the gains and losses would have been classified as net investment income. The final regulations also allow taxpayers to use prior-year capital-loss carryovers against current gains.
10. Pay your advisors. When computing NIIT, your gross investment income is reduced by related deductions, including those for investment interest expenses, advisory and brokerage fees, tax planning and prep fees, fiduciary expenses, and state and local income taxes.
A word of caution: The NIIT is still practically brand-new, and the final regulations are complex. Some moves–such as reclassifying passive income as compensation–might trigger other tax consequences. Bottom line: Pay a tax pro before trying any fancy stuff. After all, you might be able to deduct her fees against your NIIT income.