Beat the Net Investment Income Tax

Here is some important information regarding the net investment income tax (NIIT), which may be relevant to your financial situation. 

NIIT Overview 

The NIIT is a 3.8 percent tax that could apply if your modified adjusted gross income (MAGI) exceeds $200,000 (single filers), $250,000 (married, filing jointly), or $125,000 (married, filing separately). It targets the lesser of your net investment income or the amount by which your MAGI exceeds the thresholds. 

What Qualifies as Net Investment Income? 

Net investment income includes income from investments (such as interest, dividends, and annuities), net rental income, and income from businesses in which you don’t materially participate. It does not include wages, self-employment income, tax-exempt income, and distributions from qualified retirement plans. 

Reducing or Avoiding the NIIT 

To mitigate the NIIT, it’s crucial to understand what’s triggering it—your net investment income or your MAGI. Here are some strategies: 

1. Invest in municipal bonds. Pick bonds that are exempt from the NIIT and from federal and state taxes.
2. Donate appreciated assets. The correct asset donation avoids the NIIT and provides a tax deduction.
3. Avoid selling appreciated stock. Buy growth stocks that don’t pay dividends, and hold them.
4. Utilize Section 1031. It avoids MAGI and net investment income, and defers taxes.
5. Invest in life insurance and annuities. This typically defers tax until withdrawal.
6. Harvest investment losses. This can offset gains and reduce taxable income.
7. Invest in rental real estate. Structured correctly, this can minimize taxable income. 

Other Strategies 

• Active participation in business. It avoids classifying income as net investment income.
• Short-term rentals and real estate professional status. These also avoid classifying income as net investment income.
• Alternative marital status. Though this option may seem extreme, two single taxpayers have a higher MAGI threshold than a married couple.
• Retirement plan investments. These can reduce MAGI.
• IRA conversions. Converting traditional IRAs to Roth IRAs may trigger the NIIT but can have long-term tax benefits.
• Installment sales. They can level out MAGI over time. 

The NIIT can be complex, but strategic planning can significantly reduce its impact.