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How Net Investment Income Tax Works

        Money | Taxes

Avoiding the Net Investment Income Tax

Generally, the NIIT is a 3.8 percent levy on the lesser of two figures:

  1. The taxpayer's net investment income, or
  2. The amount of adjusted gross income that the person brings in over the year in excess of the minimum income levels we just discussed.

In the case of estate and trust investors, the 3.8 percent rate applies to:

  1. The lesser of the person's net investment income that hasn't been distributed, and
  2. The amount of the taxpayer's adjusted gross income that's greater than the dollar amount at which the highest tax bracket begins for an estate or trust for the tax year [sources: IRS, Nitti].

As you may have noticed by now, the NIIT is likely to apply to a relatively small segment of high earners who derive at least some of their income from passive sources like owning property or making financial investments. Indeed, the income threshold that has to be reached in order for the tax to kick in cuts the NIIT-paying public down to about two percent of American taxpayers [sources: IRS, Nitti].

A closer look shows that, in actuality, it is an even smaller slice of wealthy Americans who are on the hook for most of the tax. The NIIT is expected to raise $123 billion from 2013 to 2019. A Tax Policy Center analysis indicates that the country's wealthiest one percent will bear 88 percent of that tax bill. Drilling down even further, the analysis shows that more than half of the NIIT will be paid by the richest 0.1 percent of Americans [sources: IRS, Nitti, Tax Policy Center].

If your financial situation means you're on the hook for the Net Investment Income Tax, there are some things you can do to reduce (or eliminate) your tax burden. Whether any of these options are feasible for you may depend on how much money you're losing to the tax. And, perhaps, how much you like your spouse. By divorcing, a married couple increases the threshold at which they will be subject to the NIIT from $250,000 to $400,000 ($200,000 per person) [source: Erb].

Taxpayers looking for a less aggressive way to cut down on the NIIT have at least a couple of other options. Most of them are aimed at reducing or eliminating investment income or lowering adjusted gross income so that it falls below the threshold level at which the tax kicks in [source: Erb].

One method is to invest in your state or local government. That's right, money earned on interest and dividends from state and municipal bonds isn't considered investment income. It also isn't included in a taxpayer's adjusted gross income, meaning that it can help shield you from the NIIT if you make money on other investments [source: Erb].

Feeling generous? Consider donating investment property to a charity, so that you can deduct the gift from your income and won't be forced to recognize any appreciation in value as a capital gain. Or, loan some money to your business: Interest payable isn't considered investment income if the company is yours and the venture is legitimate. If you play an active role in the business, you can also avoid paying the NIIT on any money earned from it, even dividends and royalties [source: Erb].

If the bulk of your investment income comes from real estate, rather than running a business or working a full-time job, you may want to consider hitting the books. While rents are generally subject to the NIIT, the tax doesn't apply to license realtors who spend a significant chunk of their work time on real estate endeavors [source: Erb].


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