NEW YORK - Starting in 2013, high-income taxpayers will face a 3.8% tax on their net investment income (the net investment income tax or NIIT). “The NIIT is an extra tax that is imposed in addition to your regular income tax,” says Scott Weiner, senior tax analyst at Thomson Reuters. “It will be reported and paid for the first time with Form 1040 that is filed next April. However, a few judicious moves before year-end may help to reduce the bite of this new tax.”Below, Weiner explains what individuals need to understand about the NIIT:
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Individuals affected by the NIIT. The NIIT affects only individuals whose adjusted gross income (AGI) exceeds certain thresholds: $250,000 for married taxpayers filing jointly and surviving spouses; $125,000 for married taxpayers filing separately; $200,000 for unmarried taxpayers and heads of household.
AGI is the figure at the bottom of page 1 of Form 1040. It is equal to your gross income minus certain “above-the-line” deductions, but before subtracting your personal exemptions and standard or itemized deductions. If you claim an exclusion for foreign earned income, you must add it back to AGI for purposes of the NIIT.
If your AGI is no more than the thresholds listed above, you will not have to pay the NIIT for this year. If it exceeds those thresholds, you will be subject to the NIIT on all or part of your net investment income. The amount actually subject to the 3.8% tax is the lesser of your net investment income or the amount by which your AGI exceeds the applicable threshold.
Strategies to reduce NIIT. There are two strategies that may help to reduce or avoid the NIIT― reducing your net investment income and reducing your AGI. For example, you should think twice before converting a traditional IRA into a Roth IRA, because the required inclusion in income will increase your AGI. But increasing your itemized deductions, such as charitable contributions, will not reduce your NIIT, since AGI is figured before subtracting itemized deductions.
Net investment income subject to the tax. “Net investment income” is investment income minus the deductions that are allocable to that income, such as brokerage fees. There are three general categories of investment income. The first is gross income from interest, dividends, annuities, royalties, and rents. These items are included in investment income unless they were derived in the ordinary course of an active trade or business. However, tax-exempt interest is not subject to the NIIT, which may make tax-exempt bonds more attractive starting in 2013.
The NIIT may also make dividend-paying stocks less attractive. The top income tax rate on qualified dividends, which had been 15%, is now 20%, and on top of that there is the 3.8% NIIT, for a total tax rate of 23.8%. If you own stocks that pay little or no dividends, you will still have to pay the NIIT on the capital gain when you sell them, but you can defer the tax and control the timing of the sale.
The second category is gross income from a passive activity, defined as a trade or business activity in which the taxpayer does not materially participate. Material participation can be achieved by meeting any of seven tests, such as by participating in the activity for more than 500 hours during the year.
The passive activity rules give you some leeway to group businesses and rental activities together to satisfy the material participation standards and avoid characterization of activities as passive. As a rule, your initial grouping cannot be changed unless a change in circumstances makes the grouping inappropriate. However, you have a one-time-only opportunity to regroup activities if the NIIT makes a different grouping more beneficial. You can make the regrouping election in 2013 if you are subject to the NIIT in 2013.
You can take advantage of the regrouping election to treat net income from the newly combined group as non-passive business income and avoid the NIIT on that income. But keep in mind that this move can adversely affect your regular income tax, by transforming passive income that can be offset with passive losses into nonpassive income that cannot be offset by passive losses.
The third and final category of net investment income is taxable net gain on sales of property, other than property held in an active trade or business. The 3.8% tax, combined with the top 20% tax rate on capital gain, will increase the importance of harvesting unrealized paper losses to offset gains realized earlier in the year. If you sell a stock at a loss, you can buy it back after the 30-day “wash sale” period.
Certain types of gain are excluded from gross income, and therefore are not subject to the NIIT. For example, up to $250,000 of gain on the sale of a principal residence ($500,000 for a married couple) is tax-free. Gain in excess of these limits, or gain on the sale of a second home or vacation home, is subject to the NIIT. Other types of gain that are excluded from the NIIT are gain on the sale of qualified small business stock and gain on a like-kind exchange.
The NIIT should be taken into account in timing taxable sales. An installment sale, which allows gain to be spread out over more than one year, should be considered if it will help avoid or reduce the NIIT in each year. You can wait until you file your 2013 return to decide whether to use the installment method of reporting.
Distributions from qualified retirement plans, including individual retirement accounts (IRAs) or Roth IRAs, are not subject to the NIIT. However, a distribution from a traditional (non-Roth) IRA may still make you subject to the NIIT because it is included in AGI. To avoid the bump-up in AGI, a taxpayer who is 70½ or older should consider making a qualified charitable distribution of up to $100,000 directly from the IRA to a charity.
Taxpayers should consult with a personal tax adviser before applying these or other tax strategies.
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