Year-end Planning: Reducing Exposure to the 3.8% Surtax on Unearned Income

General background – Certain unearned income of individuals, trusts, and estates is subject to a surtax (i.e., it’s payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), for individuals is 3.8% of the lesser of:

  • net investment income (NII), or
  • the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).

MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income (net of the deductions and exclusions disallowed with respect to the foreign earned income).

For an estate or trust, the surtax is 3.8% of the lesser of (1) undistributed NII or (2) the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

For 3.8% surtax purposes, NII is investment income (see below) less deductions properly allocable to such income. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in NII.

Investment income is:

  • gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn’t apply,
  • other gross income derived from a trade or business to which the 8% surtax contribution tax does apply, and
  • net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax doesn’t

The 3.8% surtax applies to a trade or business only if it is a Code Sec. 469 passive activity of the taxpayer or a trade or business of trading in Code Sec. 475(e)(2) financial instruments or commodities. Investment income doesn’t include amounts subject to self-employment tax, distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn’t apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn’t treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as NII only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

Overview of year-end strategies – As year-end nears, a taxpayer’s approach to minimizing or eliminating the 3.8% surtax will depend on his estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year, others should try to see if they can reduce MAGI other than unearned income, and others will need to consider ways to minimize both NII and other types of MAGI.

  • Illustration 1 – For 2015, Joan, a single taxpayer, estimates she will have MAGI of $200,000, consisting of $180,000 of salary and non-investment earnings and $20,000 of NII. Since Joan’s MAGI is not above the level that would subject her to the 8% surtax, her year-end strategy for the surtax will be to avoid-if feasible, from the investment and practical viewpoint-realizing any additional income before the end of the year that will cause her to be subject to the surtax.
  • Illustration 2 – Assume the same facts as in the first illustration, except that Joan’s MAGI will include

$200,000 of salary and non-investment earnings plus $20,000 of NII. Since all of her NII of $20,000 is now subject to the surtax, she should try to avoid, to the extent possible, having any additional NII for the balance of the year since any additional NII will also be subject to the surtax.

  • Observation – Since, in illustration (2), all of Joan’s NII of $20,000 will be subject to the surtax, an increase in income other than NII will have no effect on the amount of her NII that is subject to the
  • Illustration 3 – In January of 2015, Jack, a single, self-employed taxpayer, sold investment land for a

$100,000 gain and does not anticipate selling any other investments during the balance of this year. He won’t have other NII. He estimates that he will have $100,000 of self-employment earnings and other non-investment-income for the year. Thus, Jack will be exactly at the $200,000 threshold for single taxpayers. He should, to the extent feasible and practical, defer additional amounts of earned income over $100,000 to 2016, as every additional dollar of earnings over that sum will expose a dollar of his $100,000 NII to the 3.8% surtax. For example, if he gets extra business toward the end of the year, Jack should consider deferring some of his billings until after year-end.

Re-examine passive investment holdings – The 3.8% surtax applies to income from a passive investment activity, but not from income generated by an activity in which the taxpayer is a material participant. One subject a “passive” investor should explore with a tax adviser knowledgeable in the passive activity loss (PAL) area is whether it would be possible (and worthwhile) to increase participation in the activity before year-end so as to qualify as a material participant in the activity.

In general, a taxpayer establishes material participation by satisfying any one of seven tests, including: participation in the activity for more than 500 hours during the tax year; and participation in the activity for more than 100 hours during the tax year, where the individual’s participation in the activity for the tax year isn’t less than the participation in the activity of any other individual (including individuals who aren’t owners of interests in the activity) for the year. Special rules apply to real estate professionals.

  • Caution – Becoming a material participant in an income-generating passive activity wouldn’t make sense if the taxpayer also owns another passive investment that generates losses that currently offset income from the profitable passive

Taxpayers that own interests in a number of passive activities also should re-examine the way they group their activities. A taxpayer may treat one or more trade or business activities or rental activities as a single activity (i.e., group them together) if based on all the relevant facts and circumstances the activities are an appropriate economic unit for measuring gain or loss for PAL purposes. A number of special “grouping” rules apply. For example, a rental activity can’t be grouped with a trade or business activity unless the activities being grouped together are an appropriate economic unit and a number of additional tests are met. And real property rentals and personal property rentals (other than personal property rentals provided in connection with the real property, or vice versa) can’t be grouped together.

Once the taxpayer has grouped activities, he can’t regroup them in later years, unless a one-time-only “fresh-start” regrouping is allowed. But if a material change occurs that makes the original grouping clearly inappropriate, he must regroup the activities.

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. 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.

  • Recommendation – A taxpayer who expects to realize a gain on a principal residence substantially in excess of the applicable threshold, and is planning to sell either this year or the next, should try to fine-tune the timing of the sale so as to minimize the gain’s exposure to the 3.8% surtax, and reduce his overall tax
  • Illustration 4 – A married couple will earn a combined salary of $290,000 for 2015. They plan to retire and move to a sunnier climate next Their combined earnings for 2016 won’t exceed $150,000. They plan to sell their principal residence for $1.2 million, and should net a gain of about $700,000, of which $500,000 will be excluded.

If they sell this year, they’ll have more than $464,850 of taxable income and will wind up in the top tax bracket (39.6%). Additionally, they will pay a $7,600 surtax (3.8%) and at least part of their $200,000 capital gain will be subject to a 20% tax. If they can wait until next year to sell at around the same price, and have no other gains or losses or other investment income, then only $100,000 of their home-sale gain will face the 3.8% surtax. The surtax equals $3,800, namely 3.8% of the lesser of (a) $200,000 NII; or (b) $100,000 (excess of $200,000 NII +

$150,000 of other gross income over the $250,000 threshold for marrieds filing jointly). Additionally, all of their capital gain on the home sale likely will be subject to a 15% tax.

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).

  • Recommendation – Higher-income employees should use designated Roth accounts if their retirement plans offer this option. A designated Roth is a separate account in a Code Sec. 401(k) , Code Sec. 403(b) , or Code Sec. 457 plan to which an employer allocates an employee’s designated Roth contributions and their gains and Instead of making elective, pre-tax contributions to his regular account, the employee directs that part or all of the contribution be made to a nondeductible designated Roth account within the plan. When a designated Roth account is set up within a Code Sec. 401(k) plan, it’s called a Roth 401(k). Note that unlike regular Roths, where contributions can’t be made by higher-income individuals, there is no income limitation on annual contributions to a designated Roth. Workers of all income levels are eligible to contribute to such retirement accounts.

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:

  • If possible, time conversions so as to keep MAGI below the applicable threshold
  • If the MAGI dollar threshold will be exceeded in any event, delay the conversion until next year if there is substantial NII this year but there will be low or no NII next Or do the reverse – accelerate a conversion into this year if there is low or no NII in 2015 but there is likely to be substantial NII in 2016.

Timing considerations for required minimum distributions – For the 3.8% surtax purposes, investment income doesn’t include distributions from tax-favored retirement plans, such as qualified employer plans and IRAs. But MAGI does include taxable distributions from qualified employer plans and IRAs, including required minimum distributions (RMDs) from qualified plans and IRAs.

Taxpayers nearing their MAGI threshold, or who already exceed it because of other income, may have an opportunity to plan RMDs to avoid exposing their NII to the 3.8% surtax. For example, taxpayers who attain age 701/2 in 2015 may delay taking their first RMD (i.e., for 2015) until their required beginning date of Apr. 1, 2016. This would be advisable where taking the first distribution in 2015 will cause the distributee’s MAGI to exceed the threshold amount that triggers the 3.8% surtax on NII, but deferring the distribution until next year will not have the same effect because the distributee’s income from other sources will be much lower. However, when deciding if deferring the first RMD makes sense, note that doing so does not absolve the taxpayer from making an RMD for the second distribution year (i.e., for 2016).