Tax under magnifying glass Ever wonder where the phrase “nit picking” came from? Nit picking was common and necessary in days of old to stop parasites from infesting us. Today, we are fortunate that very little actual “nit picking” needs to take place. It seems ironic, however, that one of the newest taxes carries a name that brings up this association.

The Net Investment Income Tax

NIIT stands for the Net Investment Income Tax (or, as much of the popular press refers to it, the “Obamacare Surtax” or “Affordable Care Tax”) and is an additional 3.8% investment income levy that applies above and beyond other taxable income tax rates. Many people have not heard of the NIIT; and those who have often think it does not apply to them. Even in our own industry, many professionals do not fully understand it or know what can be done to potentially reduce its impact. The NIIT applies to individuals with over $200k in modified adjusted gross income (MAGI), or couples with over $250k in MAGI. It does not directly apply to earned income (the income that you get via a paycheck) or actively-generated income (your personal business income that is actively generated). But, each tax year, income of all types is considered to determine whether or not someone is subject to the NIIT. For those who are subject to the NIIT, typically the tax directly applies to investment income, such as interest, dividends, and capital gains (both long- and short-term). For capital gains, keep in mind that this is inclusive of all capital gains and not just gains on stocks (more on this shortly). It typically applies to passive income, like rental and royalty income. This is not a complete list, of course. Your tax advisor can give you more details, and they should be consulted when making tax decisions.

Think beyond stocks

We mentioned that capital gains can be subject to the 3.8% NIIT. Not only does this include the capital gains on stocks, but it also includes gains on bonds and real estate. Many fixed income portfolios generate not only interest income, but distribute capital gains as well. Real estate sales also generate capital gains. The only exclusion for this is the ‘primary home exclusion’, if applicable, and Section 1031 exchanges. The reason it’s important to be mindful of capital gains on all sorts of investments is that many investors think their non-account activities don’t generate the same taxes. But in the eyes of the IRS, a capital gain is a capital gain. This includes the sale of rental or investment property, sale of a vacation home or condo, and sale of a partnership interest or a business.

Beware of transactions that may trigger the NIIT

Before your clients breathe a sigh of relief and say, “Okay, whew, it doesn't apply to me,” realize that the income calculation is not always obvious. Here’s an example of how an investor could unsuspectingly trigger this new tax:

John, a single filer, had $180k in income for the year in 2015. He also received $18k in interest and dividends from his investments. This put his 2015 income level for the purposes of the NIIT at $198k. He is below the threshold and not subject to the NIIT.

Now, let’s assume John also had $50k worth of capital gains distributions generated by his portfolio investments. Now his income is $248k, with $48k of it subject to the extra 3.8% NIIT.

Let’s add one more scenario to John’s situation. Let’s say John sold a condo he has owned for quite a while that had a low cost basis. His capital gain on the sale is $400k. John now has an income level of $648k! And $448,000 of it is subject to the 3.8% Net Investment Income Tax.

This scenario is not out of the ordinary. Every year people assume they are “in the clear” because their earned income fell below various thresholds. But there’s more to taxable income than simply earned income.

Guiding your clients

How can you help prevent your clients from being among those investors surprised by unexpectedly large tax bills? Consider helping your clients invest for the long term and be smart about which investments are used. For example, tax-exempt interest (like that generated by municipal bonds) are exempt from the NIIT and deferred capital gains are not taxed until they are realized. Also, think twice before “spring cleaning” your clients’ portfolios to avoid events that generate multiple NIIT triggers in a single year.

The bottom line

The more advisors – and investors – know, the more they can plan and put themselves in better positions. The same is true when it comes to taxes. Understanding the NIIT – what it taxes and how it is triggered – can potentially help you manage its impact on client portfolios in any given year.