Background

As you know, the new 3.8% Medicare tax on net investment income, which we will call the NIIT, is effective for tax years beginning on or after 1/1/13. Following are some planning ideas that may allow individual taxpayers to avoid or minimize the NIIT.

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 foreign-source income of U.S. citizens and residents living abroad net of certain deductions and exclusions [IRC Sec. 1411(d)].

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 [IRC Sec. 1411(c)].

• ·         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. Gross income from nonpassive business activities (other than the business of trading in financial instruments and commodities) is excluded from the definition of net investment income for NIIT purposes, and so is gain from selling property held in such activities [IRC Sec. 1411(c)].
• ·         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).

Impact on Trusts and Estates. Although not discussed, trusts and estates can also be hit with the NIIT [IRC Sec. 1411(a)(2)]. For them, the NIIT applies to the lesser of: (1) the trust’s or estate’s undistributed net investment income or (2) the trust’s or estate’s AGI in excess of the threshold for the top trust federal income tax bracket. For 2013, that threshold is only $11,950. Special rules apply to certain types of trusts. See Prop. Reg. 1.1411-3 for the NIIT rules that apply to trusts and estates.

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), the client’s NIIT exposure will mainly depend on his or her 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, the client’s NIIT exposure will mainly depend on his or her 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.

Example 1: Targeting Net Investment Income.

In 2013, Butch will file as an unmarried individual. Unless something changes, he will have $350,000 of MAGI, which will include $90,000 of net investment income. He will owe the 3.8% NIIT on all of his net investment income (the lesser of excess MAGI of $150,000 or net investment income of $90,000).

As you can see, Butch’s exposure to the NIIT mainly depends on his net investment income level. Therefore, he should focus first on strategies that will reduce net investment income. For instance, he could sell loser securities from his taxable brokerage firm investment accounts to offset earlier gains from those accounts. When calculating allowable deductions allocable to investment income, he should select a method that maximizes such deductions.

In contrast, strategies that would reduce AGI would not do Butch any good unless they reduce it by a bunch. For instance, making an additional $10,000 deductible to a tax-favored retirement account would not by itself reduce Butch’s NIIT bill.

Example 2: Targeting AGI.

In 2013, Chelsea and Cliff will file jointly. Unless something changes, they will have $300,000 of MAGI which will include $110,000 of net investment income. They will owe the 3.8% NIIT on $50,000 (the lesser of excess MAGI of $50,000 or net investment income of $110,000).

As you can see, the couple’s exposure to the NIIT mainly depends on their AGI level. Therefore, they should focus first on strategies that would reduce AGI. For instance, making additional deductible contributions of $20,000 to tax-favored retirement accounts would reduce their AGI and therefore reduce their NIIT bill. Selling loser securities from their taxable brokerage firm investment accounts to offset earlier gains from those accounts would also reduce AGI.

In contrast, the method used to calculate allowable deductions allocable to investment income would not by itself reduce Chelsea’s and Cliff’s NIIT bill unless it reduces net investment income by a very large amount (which is unlikely).

Example 3: Planning to Stay Safe.

In 2013, Dirk will file as an unmarried individual. Unless something changes, he will have $199,000 of MAGI which will include $25,000 of net investment income. Dirk is exempt from the 3.8% NIIT because his MAGI is below the $200,000 threshold for unmarried individuals. Therefore, he should try to make sure things stay that way by not engaging in transactions that will increase his AGI. If his AGI does go up, say, because he sells some winner securities from his taxable brokerage firm account, Dirk should try to make offsetting moves that will lower his AGI back below the $200,000 threshold. For instance, selling some loser securities or making an additional deductible contribution to a tax-favored retirement account could do the trick.

Example 4: Planning around Impact of One Big Transaction.

In 2013, George and Glenda will file jointly. Between now and year-end they expect to sell their greatly appreciated vacation home, which they have owned for many years, for a whopping $600,000 gain. That profit will be fully taxable for FIT purposes and it will also count as investment income for NIIT purposes. To keep things simple, let’s stipulate that George and Glenda will have no other investment income and no capital losses for 2013. But they will have $125,000 of MAGI from other sources (pension income, taxable Social Security benefits, taxable retirement account withdrawals, and so forth).

Due to the big vacation home profit, the couple’s net investment income—unless something changes—will be $600,000 (all from the vacation home sale) and their MAGI will $725,000 ($600,000 from the vacation home plus $125,000 from other sources). They would owe the NIIT on $475,000 [the lesser of: (1) net investment income of $600,000 or (2) excess MAGI of $475,000 ($725,000-$250,000 threshold for joint-filing couples)]. The NIIT would amount to $18,050 (3.8% × $475,000). Ouch!

In this example, the sole source of NIIT exposure is the big gain from selling the vacation home, and the NIIT exposure depends mainly on AGI. Therefore, George and Glenda should consider the following strategies:

• ·         Sell the vacation home on the installment plan to spread the big gain over several years and thus minimize or eliminate exposure to the NIIT.
• ·         If possible, swap the vacation home in a Section 1031 exchange, which would defer the big gain and thus eliminate exposure to the NIIT for now.
• ·         Take steps to reduce AGI, which would reduce (but not eliminate) exposure to the NIIT.

Specific Strategies to Reduce This Year’s Net Investment Income

Net investment income can be reduced by:

• ·         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 selling, swapping property that qualifies for Section 1031 like-kind exchange treatment to defer the gain until the property received in the exchange is eventually sold. (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.)
• ·         Selecting a method for determining deductions allocable to gross investment income that will maximize such deductions and thereby reduce net investment income. However, deductions that exceed gross investment income don’t do any good for NIIT purposes, and they cannot be carried over to the following year for NIIT purposes.
• ·         If possible, becoming more active in rental and business activities (including those conducted through partnerships and S corporations) to “convert” them from passive to nonpassive by meeting one of the material participation standards. That would make income from the activities exempt from the NIIT, because it does not apply to income from nonpassive business activities (including rental activities that rise to the level of nonpassive business activities).
• ·         To facilitate the preceding strategy, consider taking advantage of the one-time opportunity to regroup activities for purpose of applying the passive activity rules.

Warning: “Converting” income-producing activities from passive to nonpassive could have the negative side effect of reducing the amount of currently deductible passive losses.

Specific Strategies to Reduce This Year’s AGI

AGI can be reduced by:

• ·         Selling loser securities held in taxable brokerage firm accounts to offset earlier gains in such accounts. (This will also reduce net investment income.)
• ·         Gifting soon-to-be-sold appreciated securities to children and letting them sell them to avoid recognizing gains on the parent’s return. (This will also reduce the parent’s net investment income.) 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 net investment income.)
• ·         Instead of selling, swapping property that qualifies for Section 1031 like-kind exchange treatment to defer the gain until the property received in the exchange is eventually sold. (This will also reduce net investment income.)
• ·         Instead of cash, gifting appreciated securities to IRS-approved charities. That way, gains won’t be included on the donor’s return. (This will also reduce the donor’s net investment income.)
• ·         Maximizing deductible contributions to tax-favored retirement accounts such as 401(k) accounts, SEPs, and defined benefit pension plans.
• ·         For cash-basis self-employed individuals, deferring business income into 2014 and accelerate business deductions into 2013.

Longer-term NIIT Avoidance Strategies

The following ideas may not do much to reduce or eliminate this year’s exposure to the NIIT, but they could be beneficial in the long run.

• ·         Convert traditional retirement account balances to Roth IRAs, but watch out for the impact on AGI in the conversion year. The deemed taxable distributions that result from Roth conversions are not included in net investment income (see TAM-1605), but they increase AGI—which may expose more of the client’s investment income to the NIIT in the conversion year. Over the long haul, however, income and gains that build up in a Roth IRA will usually be bullet-proof with respect to the NIIT because qualified Roth distributions are not taxable for FIT or NIIT purposes. Because qualified Roth distributions are not included in AGI (unlike the taxable portion of distributions from other types of tax-favored retirement accounts and plans), qualified Roth distributions will not increase the client’s exposure to the NIIT by increasing AGI.
• ·         Invest more taxable brokerage firm money in tax-exempt bonds. This would reduce both net investment income and AGI. Use tax-favored retirement accounts to invest in securities that are expected to generate otherwise-taxable gains, dividends, and interest.
• ·         Invest in life insurance products and tax-deferred annuity products. Life insurance death benefits are generally exempt from the FIT and are thus exempt from the NIIT too. Also, such death benefits will not increase the recipient’s exposure to the NIIT by increasing AGI. Earnings from life insurance contracts are not taxed until they are withdrawn. Similarly, earnings from tax-deferred annuities are not taxed until they are withdrawn.
• ·         Invest in rental real estate and oil and gas properties. Rental real estate income is offset by depreciation deductions, and oil and gas income is offset by deductions for Intangible Drilling Costs (IDC) and depletion. These deductions can reduce both net investment income and AGI.
• ·         Invest taxable brokerage firm account money in growth stocks. Gains are not taxed until the stocks are sold. At that time, the FIT and NIIT impact of gains can often be offset by selling loser securities held in taxable accounts. In contrast, stock dividends are taxed currently, and it may not be so easy to take steps to offset them.

 

 

Information provided by Thompson Reuters