Strategies for Reducing the Net Investment Income Tax

William Perez writes: Tax planning for the Net Investment Income Tax is similar to traditional tax planning. The goal is to manage net investment and adjusted gross income in an effort to reduce the amounts that are subject to tax. However, the net investment income tax (NIIT) adds further complexity, as the NIIT is based on the lesser of either adjusted gross income over a threshold amount or net investment income for the year. Planning strategies for the NIIT focuses on managing adjusted gross income, managing investment income or managing both.

First let's start with an overview of how the net investment income tax is calculated. The NIIT is a surtax at a rate of 3.8% on a base of income that is the lesser of one's:

• Modified adjusted gross income over the threshold amount, or
• Net investment income.

The relevant thresholds are:

Net Investment Income Tax Thresholds
Filing status	Modified Adjusted Gross Income
Married Filing Jointly or Qualifying Widow(er)	$250,000
Single or Head of Household	$200,000
Married Filing Separately	$125,000

Thus, to reduce the NIIT, one could reduce AGI or reduce net investment income (or both). For example, if AGI can be reduced below the relevant threshold, then the NIIT would not apply as this would create a negative figure that when multiplied by the tax rate becomes zero. Similarly, if AGI is over the threshold amount, reducing AGI and/or net investment income reduces the amount of income subject to the NIIT.

For example, reducing the amount of capital gains that are earned for the year reduces income, which reduces AGI. And since capital gains are included in net investment income, reducing gains reduces net investment income as well.

An additional planning consideration is managing income around the thresholds, which is based on adjusted gross income. AGI is total income less those deductions found on the front of the 1040. Itemized deductions, by contrast, do not reduce AGI.

I spoke with Robert Keebler, CPA, of Keebler & Associates LLP, to discuss tax planning strategies for the net investment income tax.

"Planning for the net investment income tax is very client specific and depends on where you are and where you fit. The two basic strategies are to

• "Reduce adjusted gross income below the relevant threshold ($250,000 for married couples filing jointly), and/or
• "Reduce net investment income."

Tax-Sheltered Investments

Consider using "statutory tax shelters like life insurance."  With life insurance, any "growth [due to investment earnings] is sheltered [against current taxes], and the death benefit is tax-free." By comparison, if funds were invested in a taxable account, any earnings would be subject to tax and the net investment income tax. Placing investable assets in life insurance functions to remove investment income from adjusted gross income and from net investment income.

Consider "deferred annuities, after maxing out 401(k) and other retirement plan contributions. Annuities shelter earnings from being [taxed] immediately." Like 401(k)s, income from annuities can be spread out over time, which can help smooth out income over a longer period of time. Spreading out income over a longer period of time can help keep adjusted gross income under the threshold, or can help to avoid big spikes in income (and thus big spikes in tax).

Also, consider Roth IRAs and Roth 401(k) plans. Income distributions from a Roth plan are not included in income (as long as taxpayers take a qualified distribution). Since income from a Roth plan isn't included in income, it is "not included in adjusted gross income and not included in net investment income."

What about converting pre-tax retirement assets into a Roth IRA? Here clients will need to "run the math" and see if converting to a Roth makes sense. On the one hand, the amount converted to a Roth increases income and increases AGI, which could create both income tax and NIIT liabilities. On the other hand, future income from the Roth plan would be tax-exempt.

Strategies for Passive Income

Consider investment opportunities where you can depreciate the cost of investment, such as rental real estate. "Depreciation works so well" to reduce the amount of rental income subject to tax. Similarly, clients may want to consider oil and gas investments, which offer a "large depletion deduction upfront and deduction of most intangible drilling costs." Due to these deductions, oil and gas can be more tax-advantageous than other types of investments. These strategies function to reduce the amount of investment income subject to tax.

Taxpayers who own real estate and rent that building to their business (so-called self-rentals) may find that their rental income is subject to the 3.8% NIIT.

Taxpayers who own multiple rental properties or multiple passive businesses may want to consider how their passive activities are grouped together for the purpose of calculating the passive activity loss limitations. The IRS is providing an opportunity for taxpayers to regroup their passive activities. This can result in a more tax-efficient way of handling passive losses, which in turn can result in less income being subject to tax.

Capital Gains Income

Consider using installment sales when selling real estate and other significant capital assets. In an installment sale, the seller finances the buyer's purchase of the asset through a loan. By using an installment sale, taxpayers can choose to spread out capital gains income over the life of the loan. This will "smooth out income" over multiple years.

Consider the use of Charitable Remainder Trusts. Taxpayers can "drop property in there" and draw "distributions for the rest of their life, while the remainder goes to charity." Income generated in this way is subject to the NIIT, but the income can be spread over multiple years. For example, taxpayers could "sell highly appreciated assets inside the trust, and distribute that income over a longer period of time."

Consider the use of Charitable Lead Trusts. Taxpayers can "get a charitable deduction" upfront for contributing assets to the trust, and get to "keep gains off the tax return." This "works well for very generous" clients.

Mr. Keebler recommends that taxpayers see their tax professional right away to plan out how the net investment income tax will impact them. Taxpayers may also need to make estimated tax payments to avoid owing taxes when they file their returns.