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Keep coping with NII tax

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in Small Business Tax,Small Business Tax Deduction Strategies

The Trump administration wants to repeal the Affordable Care Act (ACA), aka Obamacare. The health care law includes the 3.8% tax on “net investment income” (NII).

Strategy: Don’t assume the NII tax will be eliminated for 2017. It’s still unclear whether any or all Obamacare provisions will survive.

At this point, the best approach is to stay the course, but be prepared to change midstream.

Here’s the whole story: The 3.8% tax applies to the lesser of NII or excess MAGI above an annual threshold of $200,000 for single filers and $250,000 for joint filers. NII includes typical income items like interest and dividends, capital gains and gains from investments in passive activities. But certain other items—like IRA and qualified retirement plan distributions and active business income—are excluded.

As a result, if you have NII and your MAGI is over the applicable threshold, you must pay the tax.

Example 1: Jim, a single filer, expects to have $25,000 of NII and MAGI of $210,000 in 2017. Because the excess MAGI of $10,000 is lower than his NII of $25,000, Jim owes a tax of $380 (3.8% of $10,000) under current law.

Example 2: John and Mary, joint filers, expect to have NII of $50,000 and MAGI of $350,000 in 2017. Because the NII of $50,000 is lower than the excess MAGI of $100,000, the couple would owe $1,900 (3.8% of $50,000) for the NII tax.

So what should you do in 2017 under current law? Here are some ideas to consider.

  • Invest in tax-free municipal bonds. The income is free from all federal income taxes, including the NII tax.
  • Delay large short-term capital gains. At least, if you wait until the gain qualifies as a long-term capital gain, you may benefit from the maximum tax rate of 15% (20% if you’re in the top tax bracket).
  • Harvest capital losses. The losses can offset capital gains, even gains taxed at ordinary income rates, plus up to $3,000 of ordinary income. The losses will also reduce your NII.
  • Arrange an installment sale of real estate. By spreading out your gain over several years, you might keep MAGI below the threshold for the NII tax.
  • Convert traditional IRA funds to a Roth. There’s a one-time tax hit, but future tax-free payouts won’t increase your MAGI. (Distributions from traditional IRAs don’t count as NII; but they increase your MAGI, which may increase your exposure to the NII tax.)
  • Swap real estate property via a like-kind exchange. There’s no current tax liability except to the extent you receive any “boot.”

In other words, reduce any (a) income affected by NII tax and (b) MAGI, until you see what tax changes are enacted and when they take effect.

Tip: Congress is expected to resolve these tax issues before year-end.

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