As the U.S. Congress mulls multiple versions of a new health care bill, one proposed change has been fairly consistent among Republicans — repeal of the 3.8% net investment income tax (NIIT) created by the Affordable Care Act (ACA). The current versions of both the House of Representatives’ American Health Care Act (AHCA) and the Senate’s Better Care Reconciliation Act (BCRA) would repeal the 3.8% tax levied on high income taxpayers retroactively to January 1, 2017.
Reports on recent Senate negotiations, however, suggest that some Republicans are floating the idea of retaining the NIIT to boost insurance subsidies for low income taxpayers. At this point, several scenarios are possible. Congress could pass a health care bill that repeals the tax or it could pass one that keeps it. The bill could make the repeal effective in 2017 or delay it. It’s also possible that this year will end without Congress agreeing on a health care reform bill. In light of the uncertainty about the future of the tax, high income earners would be wise to anticipate that the tax will remain in place at least for this year and plan accordingly.
The NIIT in a nutshell
The Net Investment Income Tax (also known as the Medicare contribution tax) applies to net investment income to the extent that a taxpayer’s modified adjusted gross income (MAGI) exceeds $200,000 for single tax filers, $250,000 for joint filers and $125,000 for married taxpayers filing separately. It’s calculated separately from the taxpayer’s regular income tax or alternative minimum tax liability.
The tax also applies to estates and trusts with undistributed net investment income and adjusted gross income exceeding the dollar amount at which the highest tax bracket for an estate or trust begins for the taxable year. (For 2017, the threshold amount is $12,500.) Grantor trusts, exempt trusts (for example, charitable trusts) and trusts not classified as trusts for tax purposes (for example, real estate investment trusts) aren’t subject to the NIIT.
Net investment income is computed by deducting from investment income certain expenses that can be allocated to that income (for example, brokerage fees). If a taxpayer meets the applicable MAGI threshold and has net investment income, the amount of NIIT tax liability is 3.8% of the lesser of 1) the amount by which the MAGI exceeds the threshold or 2) the net investment income.
Common examples of investment income include:
- Gains from selling investment assets (such as stocks and securities held in taxable brokerage firm accounts) and capital gains distributions from mutual funds,
- Real estate gains, including the taxable portion of a gain from the sale of a second home,
- Dividends, taxable interest and the taxable portion of annuity payments,
- Income and gains from passive business activities (meaning activities in which the taxpayer doesn’t spend a significant amount of time) and gains from selling passive partnership interests and S corporation interests, and
- Rents and royalties.
However, income from interest, dividends, annuities, rents and royalties is excluded if it’s earned in a business that isn’t a passive activity.
Notably, the tax can hit anyone who has a significant one-off shot of income or gain. For example, the NIIT could be triggered by a large gain from the sale of company stock, a big bonus or the sale of a house for a substantial profit.
While the Net Investment Income Tax is still in place, taxpayers generally can take two primary approaches to limit their liability
1. Reduce net investment income. If the net investment income is less than the excess MAGI, NIIT liability can be reduced or even eliminated by reducing net investment income. Options include:
- Selling “loser” investments to offset earlier gains in the year that would be subject to the tax,
- Postponing capital gains,
- Using an installment sale to spread a large gain over several years,
- Deferring gain with a Section 1031 like-kind exchange,
- Gifting appreciated securities to family members, and
- Donating appreciated securities instead of cash to charities.
Each of these moves also will reduce the taxpayer’s MAGI.
Income from a business will be excluded from net investment income if the taxpayer “materially participated” in the business. The IRS has several tests for material participation, but the taxpayer’s best bet is probably to increase the amount of time spent on the business before the end of the year. Participating in a business for more than 500 hours in a year — or more than 100 hours and as much as any other person — will establish material participation.
Taxpayers also could benefit by renting investment property to their businesses. Rental income from such an arrangement isn’t considered net investment income, regardless of whether the taxpayer materially participates in the business
2. Reduce MAGI. Where the excess MAGI is less than the net investment income, taxpayers have some options in addition to those noted above that reduce both MAGI and NII. For example, they can maximize their deductible contributions to tax-favored retirement accounts (401(k), SEP and defined benefit pension plans), defer income to the next year and accelerate applicable deductible expenses into this year (including self-employed business expenses and prepayable deductible investment expenses such as property taxes on investment properties, investment interest expenses and state and local income taxes on investment income).
Perhaps the easiest way to avoid the NIIT, though, is to invest in tax-exempt state and municipal bonds. Interest and dividends on these investments aren’t subject to the NIIT, and the interest isn’t included in the MAGI for NIIT purposes, which could help keep a taxpayer below the MAGI threshold for the tax.
What about the Medicare payroll tax?
In addition to the NIIT, the ACA also introduced the 0.9% Medicare payroll tax on high earners. The tax applies to Federal Insurance Contributions Act (FICA) wages and self-employment income to the extent they exceed the same thresholds used for the NIIT.
Both of the current health care bills under consideration in Congress would repeal the Medicare payroll tax. Unlike the retroactively repealed NIIT, however, the Medicare payroll tax would remain in effect through 2022.
The strategies outlined above are designed to reduce or eliminate Net Investment Income Tax liability for 2017. Should the tax survive beyond this year, we can help implement longer term strategies as needed.