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Blog

Net Investment Income Tax

Featured in the Northwest Herald

June 6, 2014

Are you subject to the new 3.8% Net Investment Income Tax (NIIT) that went into effect in 2013? If so, you may want to do planning to make sure you have paid in enough tax to avoid penalties, or to avoid paying the tax.

What is the Net Investment Income Tax?

NIIT is a 3.8% tax rate that applies to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.

What is Net Investment Income (NII)?

Net Investment income can be derived from the following:

  • Interest
  • Dividends
  • Gains from the sale of stocks, bonds, and mutual funds
  • Rents and royalties
  • Non-qualified annuities
  • Income from businesses involved in trading of financial instruments
  • Businesses that are passive activities
  • Gains from the sale of investment real estate including second homes that are not the primary residence
  • Gains from the sale of interests in partnerships and S-corporations for passive owners

What is Not Included in Net Investment Income?

  • Wages
  • Unemployment compensation
  • Operating income from a non-passive business
  • Operating income from non-passive activities, including real estate professional rentals and self rentals
  • Social Security benefits
  • Alimony
  • Tax exempt interest
  • Self-employment income
  • Gains that are excluded from gross income for regular income tax purposes. For example the exemption of $250,000 ($500,000 in case of a married couple) of gain realized on the sale of a principle residence for is excluded from both gross income and NIIT.

Individuals Subject to Net Investment Income Tax

U.S. citizens with modified adjusted gross income (AGI) above the following thresholds are subject to NIIT:

  • Married filing jointly with AGI above $250,000
  • Married filing separately with AGI above $125,000
  • Single with AGI above $200,000
  • Head of Household with AGI above $200,000
  • Qualifying window(er) with dependent child with AGI above $250,000

If you do not exceed the threshold amounts then you are not subject to NIIT. However, if you exceed the threshold amounts and have investment income then you will be subject to the 3.8% tax on net investment income.

Estates and Trusts Subject to Net Investment Income Tax

Estates and trusts with undistributed net investment income and AGI above $12,150 for 2014 are subject to NIIT except for certain trusts including the following:

  • Certain trusts that are exempt from income taxes: charitable trusts, qualified retirement plan trusts, and charitable remainder trusts
  • Certain trusts or estates in which all of the unexpired interests are devoted to religious, charitable, scientific, literary, or education purposes, or if organized to foster national or international sports competition, or for the prevention of cruelty to children or animals.
  • Grantor trusts
  • Real Estate Investment Trusts and Common Trust Funds

The lesser of net investment income or modified adjusted gross income over the specified threshold amount (see above) for the filing status is subject to the additional 3.8% tax.

Deductions allowed in computing NII

Certain deductions allocable to investment income are allowed in determining NII:

  • Investment interest expense
  • Investment advisory and brokerage fees
  • Rental and Royalty expenses
  • Tax preparation fees
  • Fiduciary fees for an estate or trust
  • State and local income taxes

Estimated Taxes and Withholding

If you expect that you may be liable for the NIIT then you should request additional withholding or make estimated tax payments as necessary to avoid an underpayment penalty.

Possible Planning Strategies

Strategies to avoid the NII tax involve reducing adjusted gross income and net investment income.

Possibilities to consider:

  • Consider deferring gains when possible including the utilization of installment sales and like-kind exchanges
  • Consult your investment broker to consider reallocating your portfolio to favor tax-exempt- and growth oriented investments
  • Defer any compensation payments for bonuses or commissions
  • Consider grouping elections to meet material participation requirements
  • Consider gifting strategies
  • Consider distributions for estates and trusts
  • Contributions to retirement accounts

Many highlights included above were obtained from “Questions and Answers on the Net Investment Income Tax,” from the IRS website. This is only a brief overview associated with net investment income tax and is by no means comprehensive.

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