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Strategies for Avoiding or Reducing the new 3.8% Net Investment Income Tax

Dukhon Tax shares strategies for Avoiding or Reducing the new 3.8% Net Investment Income Tax

new 3.8 tax bostonAs of the beginning of 2013, new Code section 1411 imposes an additional tax of 3.8% on unearned net investment income.  The so-called “Net Investment Tax” or “NIT” kicks in after certain thresholds effectively pushing up the top marginal tax rate for individuals, trusts, and estates.   The tax is actually a Medicare tax that is newly imposed upon investment income as of 2013 by the “fiscal cliff deal” or The American Taxpayer Relief Act of 2012.  Some people may not remember that specific government delay amongst the many we’ve had this year but it was the reason many people could not file their returns until mid to late February in 2013.  Also, the legislature extended many favorable deductions, credits, and provisions of the tax code but also introduced some increased rates and additional taxes (such as the “NIT”).

“Net investment income includes, but is not limited to: interest, dividends, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and business that are passive activities to the tax payer.  Net capital gains are also included, as well, including gains from the sale of real estate and gains from the sale of interests in partnerships and S corporations as to which the taxpayer is a passive owner.”  Short-term capital gains are taxed at ordinary income rates but can be offset by long-term capital losses.  Income from S corporations or partnerships in which the taxpayer actively participates is not included as well (more on that in just a bit).

How is net investment income computed?

In short, the tax is equal to 3.8% of the lesser of a) your net investment income for such taxable year or b) the excess (if any) of your MAGI over the threshold amount.  Got that?  Let’s simplify this a bit.  First, MAGI is modified adjusted gross income and, for purposes of this section, it’s equal to Adjust Gross Income (see the bottom of your 1040) increased by your foreign income that would otherwise be reduced by your foreign income tax credit.  Basically, you have to include your foreign source income regardless of the foreign tax credit.  For most people, MAGI is equivalent to AGI.  Now, the thresholds are $250,000 for married filers, $200,000 for individual filers, and $125,000 for married filing separate filers.  Once your MAGI goes above those thresholds you become “open” to the tax.  You must then compare your net investment income against the amount of MAGI over the threshold and the lesser of those two, multiplied by 3.8%, is your net investment tax.  Easy enough, right?

Pitfalls and how to avoid them

For most people, this isn’t a major concern.  However, for individuals that invest in stocks, in real estate, have interest, and passive income, this can add up pretty fast.  Your investment income may not be much but if your MAGI is high (for higher wage earners for example) then you’re possibly subject to paying an extra 3.8% on every dollar of your other net investment income.  If you have a modest stock portfolio or bought into a few partnerships, then you could see a noticeable increase in your tax over the prior year.  If you’re tax adviser has not mentioned this to you, it may be wise to make a phone call and see if this is something with which you should be concerned.  Of course, the staff at Dukhon Tax and Accounting would be more than glad to help.  Give us a call or e-mail: 617 651 0531 or [email protected].


The reason we keep saying “net” when we talk about your investment income is that you are allowed deductions before you have to make the above calculations.  Deductions allocable to rents and royalties are deductible, passive income deductions, investment interest are a few of the major ones.  For example, the interest on a loan you took to invest in a partnership in which you are passive, that’s a great deduction that will get you to the “net” amount of your investment income.  Non-deductible items include many of your other miscellaneous itemized deductions and deductions attributable to non-passive trade or business.


The big question is: how can we be creative within the confines of the tax code and avoid this thing?  There are several strategies, too numerous to list here, but the idea is to balance your current MAGI against your future MAGI with income shifting or other tax deferral strategies.  Tax-exempt vehicles like municipal interest might be a great idea (compare your taxable to non-taxable net gains after the tax and it may cover the lower interest rates on the Muni-bonds).   Tax deferred annuities may be something to consider; maybe your income is higher now and you want to try to push some of those gains out a few years.  Retirement options like 401k and IRA are always a great choice.  In some cases, ROTH conversions (turning a regular IRA into a Roth) may make sense for retirees who are expecting their RMDs to push them into the realm of NIT at retirement (not to mention the otherwise increased ordinary income tax rates).  Installment sales are a good hedge against capital gain increases (which are also subject to the tax) and could provide savings of up to 8.8% in the event that you are subject to the new higher 20% capital gain rate AND the 3.8% Net Investment Tax versus the 15% otherwise favorable rate.

In conclusion, there’s a lot to consider here and your tax adviser should be talking and thinking about these things.  Once again, we welcome you to contact Dukhon Tax and Accounting to find out how we can help you reduce your tax liability and navigate the increasingly complex system of taxation we have in our great US of A.

All the best,

The Staff at Dukhon Tax


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