NET INVESTMENT INCOME TAX
The Healthcare Act imposes a new 3.8% net investment income tax on net investment income only on those investors who have net investment income and also have high adjusted gross income exceeding a threshold amount ($250,000 for married taxpayers filing a joint return and $200,000 for single taxpayers and heads of household). It is not imposed on those taxpayers who have no net investment income or on those taxpayers whose adjusted gross income does not exceed the threshold amount.
Actually, there are many strategies to mitigate this additional tax burden. For example, as long as a taxpayer can reduce adjusted gross income to a level below the threshold amount, no matter how high the net investment income is, no net investment income tax will occur. By the same token, as long as there is no net investment income, no matter how high a taxpayer’s adjusted gross income is, there is no net investment income tax either.
There are many examples of investment income that are nontaxable, such as interest income from municipal bonds, capital gain on appreciated properties given to a charity or on death, pension income, Roth IRA withdrawals, and social security. These income items do not give rise to net investment income; and thus no NIIT will incur.
In addition, a taxpayer is in a position to manage the timing of investment income in such a way as to take advantage of the threshold amount. For example, say a single taxpayer has $190,000 adjusted gross income every year before realizing $20,000 capital gain. If this taxpayer realizes the entire $20,000 of capital gain in the same year, $10,000 will be subject to the new net investment income tax. If this taxpayer realizes only $10,000 capital gain a year in two years, the entire $20,000 capital gain will completely escape the tax. That is because a single taxpayer enjoys a $200,000 exempt amount.
Furthermore, a taxpayer can also maximize the benefits of loss on the sale of a stock investment. For example, say a single taxpayer has $200,000 of adjusted gross income every year before capital gain or loss. If this taxpayer realizes $10,000 of capital gain in the current year and $10,000 of capital loss next year, the capital gain triggers the net investment income tax, while the capital loss does not reduce it. If the taxpayer moves the $10,000 capital loss to the current year, the $10,000 capital gain is offset by the $10,000 capital loss completely. The net investment income tax on the $10,000 capital gain in the current year is completely wiped out.
Besides, a taxpayer can also control transactions that create no taxable investment income, such as installment sales, like-kind exchanges of two properties, investments in tax-deferred IRAs or tax-exempt bonds, and a sale of a principal residence. These transactions do not result in taxable income; and hence there is no net investment income tax.
It should be noted that the 3.8% net investment income tax is a flat rate, rather than a progressive rate. It applies to the taxpayer’s taxable income in excess of the threshold amount, regardless of the taxpayer’s tax bracket. As a consequence, it can potentially raise the maximum marginal tax rate for dividends and long-term capital gains to as high as 23.8% (20% + 3.8%) and for the ordinary income tax rate to as much as 43.4% (39.6% + 3.8%). Taxpayers must be aware of the consequences of these increases.
Offsetting capital losses against capital gains
Capital gains entail tax liability, but capital losses can save income tax. The amount of tax savings from a capital loss depends on what capital gain or ordinary income it is offset against. Under the Relief Act, there are seven different ordinary income tax brackets and three long-term capital gains tax rates. By the current tax rules, the short-term capital gains and losses must be offset against each other to arrive at net short-term capital gains or loss. Likewise, long-term capital gains and losses must also be offset against each other to reach net long-term capital gains or losses. Only thereafter can the net short-term capital gains/losses and the net long-term capital gain/loss be offset against each other.
Although the maximum ordinary income tax rate has increased to 39.6%, any capital loss that is offset against it can save income tax up to 39.6% as well. The long-term capital gains tax rate is also increased up to 20%. Hence, any capital loss that is offset against it can also save income tax up to 20%. In other words, higher tax rates are a disadvantage, but they can also provide advantages if there is a loss. It depends on how a taxpayer uses it. The order of gains and losses offsetting rule and the timing of realizing capital losses become quite important.
Switching between individual and business expense
Because the individual tax rate is higher than the C corporation tax rate, deductible individual expenses can save more income tax than business expenses. This may cause business expenses to be turned into individual expenses. For example, say a C corporation needs to rent an office space. Rental expense is tax deductible. Should the office space be rented under a C corporation or an S corporation? Renting as a C corporation saves income tax at a rate of only 35%; whereas, renting as an S corporation can save at a rate as high as 39.6%. In that situation, it is obviously preferable to rent it under an S corporation. This strategy could generate a great deal of tax savings.
Donating appreciated property to charity
In fact, both the high individual income tax rate and the high long-term capital gains tax rate may actually result in greater tax savings by taking advantage of charitable contributions. For example, a taxpayer has a long-term capital asset that has appreciated in value. If this asset is sold, it will result in a long-term capital gain that entails a tax liability at a maximum rate of 20%. If this asset is contributed to a charity, it is deductible at its fair market value, but the long-term capital gain is tax-exempt because the asset is not sold for consideration. This immediately saves long-term capital gains tax at 20%. Better yet, the recipient’s adjusted basis for this asset will start from the fair market value. If the recipient resells this asset, it will not realize any capital gain either because of its tax-exempt status. This strategy provides an escape route for long-term capital gains tax.
By the same principle, a taxpayer may have a short-term capital asset that has appreciated in value. If it is sold, it results in a short-term capital gain that ends up with a capital gains tax rate as high as 39.6%. If it is contributed to a charity, it is deductible at its adjusted basis and no short-term capital gain is realized. The charitable contribution has saved income tax by as much as 39.6% of its adjusted basis. Moreover, it does not create taxable short-term capital gain either, though its fair market value has increased. The tax savings are quite substantial. The recipient’s adjusted basis of the asset will, this time, start from the donor’s adjusted basis. If the recipient immediately sells the asset at its fair market value, the short-term capital gain is tax-exempt because the recipient is a tax-exempt organization. This strategy can also yield a great deal of savings of capital gains tax.
Similarly, in the case of inherited property, a good tax planning strategy can save a lot of capital gains tax too. For example, say a father owned a house all of his life and sells the house before he dies. This may result in a huge amount of long-term capital gain. A capital gain that exceeds the $250,000 statutory exclusion amount results in long-term capital gains tax. If the father does not sell the house and lets his son inherit it when he dies, the father’s entire amount of long-term capital gain would have been forgiven and the son would have inherited the house at a “step-up” basis to the fair market value at that time. If the son immediately sells the house, there is no long-term capital gain. This strategy, which works no matter how high the long-term capital gains tax rate has gone up, takes advantage of tax savings due to death.
