Avoiding the Net Investment Income Tax

The Patient Protection and Affordable Care Act not only brought us Obamacare, but also the Net Investment Income Tax or NIIT.  This new tax, which is a Medicare surtax, is a 3.8% tax on various types of investment income received by certain individuals, trusts, and estates.

Who does it apply to?

Specifically, individuals with modified adjusted gross income (MAGI) over $200,000 ($250,000 for married filing joint or a surviving spouse; $125,000 for married filing separately) must pay the 3.8% NIIT on the lesser of (1) net investment income, as defined later, or (2) the amount by which MAGI exceeds the applicable threshold.

Estates and trusts must pay NIIT on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income (AGI) over the amount at which the highest estate and trust income tax bracket begins (only $11,950 for years beginning in 2013).

The NIIT does not apply to corporations, limited liability companies taxed as corporations, or nonresident aliens.  The additional tax will be calculated on Form 8960 and reported and paid with an individual's Form 1040 or an estate or trust's Form 1041.

What is Net Investment Income?

For the purposes of NIIT, net investment income (NII) is defined as the following items.

  • Interest, dividends, annuities, royalties, and rents less properly allocated deductions.
  • Gross income from a trade or business that is a passive activity.
  • Gross income from a trade or business of trading in financial instruments or commodities.
  • Net gain from the disposition of nonbusiness property or the disposition of property held in a trade or business that is a passive activity.
  • Any income, gain, or loss attributable to an investment of working capital.

Generally, NII only includes amounts that are included in regular taxable income for the year.  Therefore, items such as tax-exempt interest are not included in NII.  Also, the following deductions, typically deducted as itemized deductions, reduce NII:

  • Investment interest expense to the extent it is allowed for regular tax purposes.
  • Property taxes on investment property.
  • State and local income taxes paid on investment income.
  • Investment expenses in excess of 2% of AGI that are allocable to investment income.

However, if the taxpayer's overall itemized deductions are limited, due to exceeding certain income thresholds, then the above deductions are reduced as well.


(1)   Lucas, a single individual, has net investment income of $100,000 and MAGI of $310,000.  Lucas's MAGI is $110,000 more than the MAGI threshold for a single individual ($310,000 – $200,000).  Lucas's NIIT is $3,800 ($100,000 net investment income × 3.8%).

(2)   George, a single individual, has $150,000 of wage income in 2013.  Additionally, he has $70,000 of taxable NII consisting of $40,000 interest and $30,000 dividends.  He also has $20,000 of tax-exempt interest income.  George's MAGI is $220,000 ($150,000 wages + $70,000 NII).  The 20,000 tax-exempt interest income is not included in MAGI nor in NII for purposes of the NIIT.  Since George's MAGI is over the $200,000 NIIT threshold for single individuals, he owes the NIIT on the lesser of his MAGI over $200,000 ($20,000) or the $70,000 taxable NII.  Therefore, George's NIIT is $760 ($20,000 × 3.8%).


Strategies for dealing with the NIIT typically find ways to either reduce your MAGI, NII, or both.  Here are a few suggestions ranging from rather simple to complex.

  • Sell securities held in taxable brokerage accounts that will generate losses to help offset any gains in the account during the year.  This will help reduce both NII and MAGI.
  • Consider donating appreciated securities to IRS approved charities.  Any gain that would have been included on your tax return is excluded, thus reducing both NII and MAGI, and you will still receive a charitable deduction based on the fair market value of the securities donated.
  • Maximize deductible contributions to tax-favored retirement accounts, such as a 401(k).  This will not decrease NII, but will reduce MAGI which may be beneficial to taxpayers that are close to the income threshold for the NIIT.
  • Consider investing more money in tax-exempt bonds or in growth stocks which typically pay smaller dividends.  Both options will reduce both NII and MAGI while you own the stocks.  When the growth stocks are sold, the negative impact of any gains can be offset by selling stocks that have declined in value.
  • Consider investing in tax-deferred annuity products.  The earnings from tax-deferred annuities are not taxed until they are withdrawn.  Plus, you can arrange to receive payments in retirement when you may expect your income to be less than it is now.  This strategy helps reduce NII currently since the earnings grow tax-free.
  • If you are considering selling an investment property or activity, you may want to consider an installment sale where you receive the sales proceeds over one or more years.  In an installment sale, instead of recognizing the entire gain in the year of sale, gain is only recognized in the proportion of sales proceeds received during the year.  This will reduce both NII and MAGI in the year of sale and the spread of gain over several years may lessen or eliminate the amount of gain subject to the NIIT.
  • If you have any investments in partnerships or S corporations that have been treated as passive activities, it may be a good year to reexamine your level of activity and involvement in those activities.  If you materially participate, which is generally defined as regular, continuous, and substantial involvement in the activity's operations, then the activity would no longer be passive; and, therefore, no longer subject to the NIIT.
  • If you find that your partnership and S corporation investments are still passive after reexaming your involvement, you may have another option.  One or more business or rental activities can be grouped together to be treated as a single activity if the activities constitute an appropriate economic unit.  Now you can look at your involvement in this grouped activity to determine if it is passive.  Here is an example to help demonstrate this concept:

Bart owns a partnership that engages in two activities, X and Y, which he has properly grouped. He participates in X for more than 500 hours during the year and is treated as materially participating in the activity. Bart only participates in Y for 50 hours during the year. But for the grouping of the two activities together, he would not be treated as materially participating in Y. But, because of the grouping, Bart is treated as materially participating in both activities. So, neither X nor Y is a passive activity. Therefore, the 3.8% NIIT does not apply to either activity.

  • If you have already grouped activities into a single activity on previously filed tax returns, then you may want to reconsider those groupings.  Due to the new NIIT, taxpayers are allowed to regroup their activities the first year they are subject to the NIIT.  Taxpayers may regroup activities only once, and a regrouping will apply to the tax year for which the regrouping is done and all subsequent years.
  • If you meet the requirements to be a real estate professional (please consult your tax advisor for these rules), then all of your rental real estate activities will not be passive activities and will no longer be subject to the NIIT.  However, since most rental real estate activities generate losses, which would decrease your NII, this strategy may only be beneficial to taxpayers who generate a large amount of income from their rental real estate activities.
  • For estates and trusts, since the income threshold is so low for the NIIT (only $11,950 for 2013), it may be beneficial to distribute sufficient income to the beneficiaries rather than accumulate income that would generate the additional tax for the estate or trust.  If the beneficiaries are not subject to the NIIT, the tax saving could be substantial.

Not all of these strategies make sense for everyone or all situations.  This new tax has added a new complex layer to tax planning, so be sure to discuss your specific situation with your professional tax advisor.