What is Net Investment Income Tax? (And Can Expats Avoid It?)
The Net Investment Income Tax (NIIT) is a by-product of the 2010 Health Care and Education Act, which resulted in substantial US tax law changes. These changes went into effect on January 1, 2013, and the NIIT principally implicates high-earning US taxpayers.
Imposed by section 1411 of the Internal Revenue Code (IRC), the NIIT applies to individuals, estates, and trusts at a rate of 3.8% when income is above the statutory threshold amounts, minus related expenses.
Net investment income tax does not apply to partnerships or corporations.
In this article, we define the types of income that qualify as net investment income (NII) and break out the qualifying income thresholds based on filing status. We also present a high-level overview of strategies that may be used to mitigate NIIT and answer a few common questions.
Let’s dig in.
Defining net investment income (NII)
Net investment income is passive income received from assets (before taxes) as defined under IRS section 469.
The net investment income tax is triggered when your modified adjusted gross income (MAGI) exceeds the statutory threshold. At that point, either your total net investment income or part of your MAGI is subject to the 3.8% tax surcharge.
The table below notes different types of income and whether it contributes toward the NIIT threshold.
Net investment income tax 2023: How to calculate what you’ll owe
Your filing status determines the income threshold that triggers the aforementioned 3.8% NIIT. However, you’re only subject to this tax if you have net investment income and your MAGI exceeds these thresholds. When calculating your MAGI, the amount is typically identical to your Adjusted Gross Income (AGI).
Important callout: If both your NII and MAGI exceed the threshold associated with your filing status, the NIIT is applied to the income type with the lowest overage. Where MAGI is the higher of the two, the 3.8% tax is applied on the excess of modified adjusted gross income (more on this later).
Below is a table summarizing the NIIT as it applies to individuals.
Note: These threshold amounts are not indexed for inflation, meaning that they remain the same from one tax year to the next.
Reporting net investment income tax
To determine your NIIT, use IRS Form 8960 to calculate your net investment income tax.
Additionally, individuals owing NIIT must make quarterly estimated payments on the amount they anticipate owing, in addition to any quarterly income payments.
Determining what you owe: Two examples
Let’s look at two hypothetical scenarios in which you would owe NIIT.
Example 1: NII overage
Let's say you are a single filer. After calculating your net investment income and corroborating that figure with your financial planner, your total NII is $20,000. Your MAGI goes over the $200,000 threshold for single filers by $10,000.
You will owe the 3.8% net investment income tax – but only on the $10,000 of NII you have — since it's less than your MAGI overage.
Your NIIT due would be $380 (.038 x $10,000).
Example 2: MAGI overage
Let's say you are a single filer. After calculating your net investment income and corroborating that figure with your financial planner, your NII total is $100,000. Your MAGI is $250,000, meaning that it goes over the $200,000 threshold for single filers by $50,000.
You will owe the 3.8% net investment income tax – but only on the $50,000 of MAGI that is in excess of the $200,000 threshold—since it's less than your NII overage.
Your NIIT due would be $1,900 (.038 x $50,000).
How to avoid Net Investment Income Tax
Being able to successfully ascertain whether you’ll owe NIIT (and how much) probably doesn’t feel like much of a win if the bottom line is that you owe. So, it’s natural to look for ways to avoid NIIT – or at least reduce it. The extent to which you can reduce your NII tax liability depends on your ability to reduce your reported MAGI or NII.
This is where individual proactivity pays dividends in the long run. After you determine that you have taxable financial accounts and other qualifying investments subject to NIIT, you should review your financial plan and tax strategy to eliminate or reduce your tax exposure.
Reducing your reported MAGI
There are a variety of strategies that US taxpayers can (and do) take to reduce their reported MAGI. It’s important to note though, that every situation is unique, particularly where US expats are concerned. This is because many strategies that are available to Americans living in the US become inaccessible or encounter complicating factors when residing outside the US.
A few common ways that you might achieve a reduction in MAGI reporting include:
- Contributing to qualified retirement plans
- Donating to charities
- Tax-loss harvesting
- Reducing income from self-employment
Reducing your net investment income
When your NII is higher than your MAGI, it’s beneficial to explore options to reduce that figure. For example, it may be beneficial to explore opportunities to meet the material participation standard. Doing so could recategorize NII-qualified income to be non-qualified, thus lowering the total amount that is vulnerable to the NIIT.
Meeting the material participation standard
To be treated as a material participant in an activity, an individual must be involved in the activity’s operations on a regular, continuous, and substantial basis. There are seven tests (of which an individual only needs to satisfy one) used to determine whether someone is a material participant.
Note: It is strongly recommended to engage a financial advisor when determining whether material participation or passive participation is the best strategic approach. US expats in particular should seek out cross-border financial advising expertise to ensure they are receiving the most holistic advice.
Common questions regarding the Net Investment Income Tax (NIIT)
Does NIIT apply to a rental property?
Yes. The IRS does classify income from rental property as income subject to NIIT in the event of a threshold overage.
Does NIIT apply to the sale of a rental property?
If the sale of a rental property resulted in capital gains, yes, that income is qualified for NIIT. However, if the sale of the rental property resulted in a loss, that figure could actually be subtracted from your overall net investment income to lower the total.
Does NIIT apply to the sale of a business?
This is a complex question that depends on a variety of factors, including but not limited to the degree to which the US taxpayer was actively involved in the business (if at all) and the extent to which income generated from the business in question can be strategically reduced to mitigate MAGI.
Can the Foreign Tax Credit be used to offset NIIT liability?
Yes – maybe. In a landmark ruling in October 2023, the US Court of Federal Claims (Christensen v. United States) determined that the FTC could be used to offset the Net Investment Income Tax (NIIT).
This ruling has hugely positive implications for US citizens living in France because the ruling is premised on an interpretation of the US-France Tax Treaty. However, it may also have exciting tax and financial planning implications for the wider US expat community.
Determining your NIIT is just one piece of a much bigger picture
Additional considerations that many US expats in particular must consider include:
- The implications of being married to a nonresident alien (NRA)
- How passive income generated by investments for children is classified
- Ascertaining what types of investment expenses are deductible when calculating NII
At Connected Financial Planning, we know that you work hard to ensure that you and your family are financially provided for the long term. Not only would we love to support you in that endeavor –we’re uniquely qualified to do so, thanks to our cross-border expertise and close client collaboration.
If you’re a US expat looking to optimize your financial planning strategy for the long term, schedule a free consultation today.
External Resources:
Topic No. 559, Net Investment Income Tax | Internal Revenue Service (irs.gov)
Modified Adjusted Gross Income (MAGI): Calculating and Using It (investopedia.com)
How to avoid the net investment income tax with material participation - SBN (sbnonline.com)
7 Ways to Reduce Your Income to Qualify for Roth IRA Contributions | Kiplinger
Material Participation Tests: Definition, IRS Rules vs. Passive (investopedia.com)