Tax on Unearned Income, and 8 Ways to Reduce your Tax
There may be a new administration in Washington, D.C., but the "Obamacare Tax" is still weighing on high-earning Americans world-wide. The Net Investment Income Tax (NIIT), also referred to as the “Unearned Income Medicare Contribution surtax”, was initiated in 2013 to fund the Affordable Care Act (aka “Obamacare”) by taxing the highest earning Americans an additional 3.8% on “unearned” or “passive” income.
If you are filing a form 1040 tax return (the default individual tax return for US citizens and green-card holders) and your gross income is over the following amounts, you may need to pay the NIIT.
$250,000 for couples filing jointly
$125,000 for married people filing a tax return without their spouse
$200,000 for single taxpayers and those filing as “Head of Household”
Your accountant will help determine your filing status and calculate your exact “modified adjusted gross income” (MAGI).
What is taxed?
In general, all taxable investment income, aka passive income, is subject to the additional 3.8% tax. However, the tax is calculated on the lesser of your net investment income or your “modified adjusted gross income” (basically, your total income) minus the above appropriate threshold. This is a relief for taxpayers whose investment income is a high proportion of their total income. Investment income includes interest, dividends, gain on sales of securities, gain on sale of property, and rental income. Net investment income does not include sale of property used in your business, the sale of your personal residence, rental income if you manage the property, income where you actively participate in the business (speak to your accountant for details), and investment income that is tax-free at the federal level (like municipal bonds).
Why are foreign residents hit harder?
The NIIT is especially noticeable to foreign residents or dual citizens for two reasons. First, a disproportionate number of foreign residents use the filing status “married filing separately.” As you can see above, this filing status is subjected to the lowest threshold for triggering the NIIT. Married filing separately has traditionally been the most unfavorable filing status from many angles, but it may still be the best or only option for a US citizen married to a “non-resident alien” (non-US citizen).
Second, the NIIT is not offset by Foreign Tax Credits. Therefore, it is more noticeable to taxpayers who are not used to paying any money to the IRS. US Citizens living and working in a foreign country, such as Israel, where tax is withheld at the source, often owe no additional money to the IRS. Now they may.
How can I reduce my NIIT?
1. If you usually file “married filing separately” because you are married to a non-citizen, discuss other options with your accountant. If you have at least one dependent (usually a child living with you) and you support your household at least 50%, you may benefit from filing as “Head of Household”. This filing status is most commonly used for single parents; however, it can also be used by US citizens or green-card holders married to non-citizens. If your spouse has no income or a salary where tax is withheld, you may benefit by filing jointly. Speak to your accountant about the possibility of getting your spouse a US tax ID and electing to file jointly.
2. If you are married to a non-citizen, speak to your tax planning advisor about restructuring assets between you and your spouse. This may need to be done over several years to avoid gift tax reporting.
3. If you have a business, discuss with your accountant how giving or loaning cash and property to your business might help reduce your future taxable gains and investment income. Interest received from your business may not be subject to the NIIT.
4. Become an active participant or manager of your investment property or a business in which you have invested. Active participation in the business (usually at least 100-500 hours a year) will move any income into the “earned” category, and will not be subject to the tax on “unearned” income. Speak to your accountant for details; some types of investments may still be considered investment income.
5. Instead of donating cash to charitable organizations, give marketable securities which have appreciated in value. You can still receive a deduction, but you will not pay tax on the gain.
6. In years where you have high gains from sales of property or securities, also sell securities where you expect to realize a loss. This will lower the net gain for the year, and thus your taxable net investment income.
7. Keep track of all costs associated with your investments – bank fees, accounting fees, investment advising expenses. These costs may help reduce your taxable investment income. (See future post on itemizing deductions.)
8. Speak to your tax adviser about financing investments with loans or a mortgage. The interest will reduce the taxable investment income.