Reducing Exposure to the NIIT (Obamacare) Surtax

Josh Nowack

October 20, 2015

Year end is tax planning time.  For those taxpayers that make more than $250,000 ($200,000 if you're single), you may have some exposure to a 3.8% net investment income tax.  This tax is assessed on your passive investments (i.e. bank interest, dividends, annuities, royalties, etc).  Real estate has other rules that MAY apply depending on whether or not you're actively involved in the administration of the property or not.  In any case, to minimize your exposure to this tax, we suggest reviewing the following opportunities:  

Use the installment method to spread out taxable gain on a sale. The entire profit from a sale ordinarily is taxable in the year of sale. But by making a sale this year with part or all of the proceeds payable next year or later, a non-dealer seller becomes taxable in any year on only that proportion of his profit which the payments he receives that year bear to the total sale price. The installment method can be a useful way to spread out gain and thereby avoid or minimize a taxpayer's exposure to the 3.8% surtax.

Another advantage of installment reporting is that it can give the seller an important degree of hindsight in deciding whether to throw profit into 2015 or 2016. An individual who makes a qualifying sale in 2015 has until the due date of his 2016 return (including extensions) to decide whether to elect out of installment reporting and report his entire profit in 2015 or to defer that part of the gain attributable to payments to be received in later years. A problem here is that regardless of how the seller elects, the buyer will still be paying for the property in installments. If the installment method isn't used, the seller will be paying taxes in the year of sale on income that won't be received until a later year or years.

Use a like-kind exchange to defer gain recognition to a low-NII year. Under the like-kind exchange rules, if specific identification and replacement period requirements set forth in Code Sec. 1031 are met, gain or loss is not currently recognized on the exchange of property held for productive use in a trade or business or for investment for property of like-kind that will be held for productive use in a trade or business or for investment. Qualified intermediaries (QIs) and multiparty deferred exchanges may be used to structure like-kind exchanges, allowing greater flexibility in qualifying for income deferral.

A like-kind exchange may be appropriate for a taxpayer who wants to realize a gain on investment property this year, but defer gain recognition until a later year when his MAGI isn't likely to exceed the applicable threshold. The taxpayer realizes the gain on the relinquished property this year, and recognizes the gain in a later year when he sells the like-kind property he receives in exchange for the relinquished property.

Adjust the timing of a home sale. Under Code Sec. 121, when a taxpayer sells a home he has owned and used as a principal residence for at least two of the five years before the sale, he may exclude up to $250,000 in capital gain if single, and $500,000 in capital gain if married. Gain on a sale in excess of the excluded amount will increase NII and net capital gain. And if taxpayers sell a second home (vacation home, rental property, etc.) at a profit, they pay taxes on the entire capital gain and all of it will be NII potentially subject to the 3.8% surtax.

It should be noted that the non-excluded portion of a home sale gain also increases a taxpayer's MAGI. Thus, the taxable portion of a home sale may cause a taxpayer to exceed the threshold amount, subject part or all of the taxable home sale gain to the 3.8% surtax, and expose other NII to the 3.8% surtax.

Recognize losses to offset earlier gains. As year-end approaches, one way to reduce NII is to recognize paper losses on stocks and use them to offset other gains taken earlier this year. What if the taxpayer owns stock showing a paper loss that nonetheless is an attractive investment worth holding onto for the long term? There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). However, a taxpayer can substantially preserve an investment position while realizing a tax loss by using one of several techniques, such as buying more of the same stocks or bonds, then sell the original holding at least 31 days later, or selling the original holding and then buying the same securities at least 31 days later.

Use Roth IRAs instead of traditional IRAs. The 3.8% surtax makes Roth IRAs look like a more attractive alternative for higher-income individuals. Qualified distributions from Roth IRAs are tax-free and thus won't be included in MAGI or in NII. By contrast, distributions from regular IRAs (except to the extent of after-tax contributions) will be included in MAGI, although they will be excluded from NII.

In general, a qualified distribution from a Roth IRA is one made: (a) after the 5-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the taxpayer's benefit); and (b) on or after he attains age 591/2; because of death or disability; or to buy, build, or rebuild the taxpayer's first principal residence. As a bonus, Roth IRA owners do not have to take required minimum distributions (RMDs) during their lifetimes (Roth beneficiaries must, however, take required distributions from the account). 

Time conversions to a Roth IRA. Taxpayers who are thinking of converting regular IRAs to Roth IRAs this year should do so with care, as the move will increase MAGI, and therefore potentially expose – or expose more of – their NII to the 3.8% surtax. Some suggestions:

 

   

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