For NIIT purposes, net investment income includes interest, dividends, annuities, rents and royalties, net capital gains, and other investment income, reduced by certain expenses that can be allocated to that income. Several types of income are excluded, including (with certain exceptions) income from an active trade or business.
NIIT doesn’t apply to everyone
Not everyone is subject to the tax, though. It’s limited to taxpayers whose modified adjusted gross income (MAGI) exceeds the following thresholds:
- Single or head of household $200,000
- Married filing jointly $250,000
- Married filing separately $125,000
Generally, MAGI is equal to adjusted gross income (AGI). But if you live and work abroad, you’ll need to add back the foreign earned income exclusion to determine your MAGI.
The tax applies to your net investment income or the excess of your MAGI over the threshold, whichever is less. So, for example, if a married couple has MAGI of $350,000, including $75,000 of net investment income, the tax is 3.8% of $75,000.
Sales can trigger the NIIT in two ways: First, a net capital gain is investment income that’s potentially subject to the tax. Second, if you’re not otherwise subject to the tax, a large gain can push your MAGI above the threshold.
An IRS webpage, “Questions and Answers on the Net Investment Income Tax,” clarifies that the NIIT also doesn’t apply to gains that qualify for the Section 121 exclusion for regular tax purposes. The tax does apply, however, to the extent gain exceeds the exclusion, as well as to gains on sales that don’t qualify for the exclusion.
For a home to qualify for the exclusion, you must own and use it as your principal residence for at least two years during the five-year period preceding the sale. And you can’t use the exclusion more than once every two years. If the home is a nonprincipal residence (a vacation home, for instance) you won’t qualify for the exemption.
Further, if you don’t meet the two-year requirement, the entire net gain is taxable — unless you meet the one narrow exception. If you’re forced to sell your principal residence in less than two years because of job loss, health issues or certain other unforeseen circumstances, you may be entitled to a prorated exclusion. Ask your tax advisor about the details if you believe that this exception might apply to you.
Strategies to reduce or eliminate the tax
If a home sale will trigger the NIIT — either because the gain will exceed the exclusion amount or because the home isn’t your principal residence — there may be strategies you can use to reduce or even eliminate the tax. They include:
Harvesting losses. If you own stocks or other investments that have declined in value, consider selling them to generate capital losses you can use to offset the gain.
Converting a second home into a principal residence. If you’re selling a nonprincipal residence, it may be possible to convert it into a principal residence, which in many cases provides only a partial exclusion.
Keeping track of improvements. The NIIT applies to profit, not gross proceeds. To the extent that you’ve made improvements to the property, it may help to reduce your profit, which may in turn help you to reduce — or perhaps avoid — the NIIT.
In fact, all of these strategies are designed to reduce your net investment income, as well as your MAGI, potentially eliminating NIIT.
A reality check
There’ve been a number of misconceptions about the NITT and home sales since the tax went into effect two years ago. Knowing the facts about the potential tax impact on the sale of your home can put your mind at ease or prompt you to look into appropriate tax strategies.
If you need a better explanation or some clarification on this article, give us a call! We’re here to help!