The 3.8% net investment income tax (NIIT), which went into effect in 2013 under the Affordable Care Act, continues to create confusion. One aspect of the NIIT (also known as the Medicare contribution tax) that’s widely misunderstood is its impact on the sale of a home. It doesn’t help that chain e-mails and other unreliable sources would have you believe that the NIIT is a “sales tax” on the gross proceeds of all home sales.
The NIIT is not a sales tax. It applies, if at all, only to profits from a home sale, not to gross proceeds. And it doesn’t apply to profits eligible for the Internal Revenue Code Section 121 home sale exclusion. The exclusion applies to the first $250,000 ($500,000 for joint filers) of gain from the sale of a principal residence. Certain home sales are subject to the NIIT, however.
How the NIIT works
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.
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 $300,000, including $75,000 of net investment income, the tax is 3.8% of $50,000, the amount by which the couple’s MAGI exceeds the $250,000 threshold.
Application to home sales
Home 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.
Recently, the IRS created the publication Questions and Answers on the Net Investment Income Tax, clarifying that the NIIT doesn’t apply to gains that qualify for the Sec. 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 example) or you don’t meet the two-year requirement, the entire gain will be subject to capital gains taxes and, depending on your MAGI, NIIT.
There’s one exception to the two-year requirement: If you’re forced to sell your principal residence in less than two years due to job loss, health issues or certain other unforeseen circumstances, you may be entitled to a prorated exclusion. For example, if you’re laid off and have to sell your home after only one year, you can claim a 50% exclusion ($125,000; $250,000 if you’re married).
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. The rules for these conversions are complex, however, and in many cases provide only a partial exclusion.
Keeping track of improvements. Remember, the NIIT applies to profit, not gross proceeds. Improvement costs generally increase your basis, reducing your profit. So it’s important to track and document those costs.
Not only do these strategies reduce your net investment income, but they also reduce your MAGI, potentially eliminating NIIT. (See the sidebar “Home sale example.”)
Consult an advisor
If you’re preparing to sell a home, consult your tax advisor to determine whether the sale will generate NIIT and to discuss tax-saving strategies.
If you have any questions regarding this article, please contact Friedman LLP at firstname.lastname@example.org or 877-538-1670.