Are You Ready for the New Investment Tax?

It's time to grapple with the new 3.8% tax on investment income.

The ordeal of 2012 taxes is barely over. But it isn't too early to understand and cushion the blow of the investment-income levy, which Congress passed in 2010 to help fund the health-care overhaul.

The tax, which took effect Jan. 1, applies to the "net investment income" of married joint filers who have more than $250,000 of income (or $200,000 for singles ). Only investment income—such as dividends, interest and capital gains—above the thresholds is taxed. The rate is a flat 3.8% in addition to other taxes owed.

"Affluent investors who ignore this tax will be in for a total shock next April 15," says David Lifson, a certified public accountant specializing in tax at Crowe Horwath in New York. Such income is typically not subject to withholding, and people won't be factoring it into their estimated taxes. Lower-bracket taxpayers who receive a windfall large enough to owe the tax will also be in for a surprise.

The new levy is one of several tax increases taking effect this year, including higher top rates on income and capital gains, limits on deductions, and an extra 0.9% payroll tax. But the 3.8% tax will cost many Americans even more.

The reason: an odd interaction between the regular income tax and the alternative minimum tax, or AMT, a separate levy that rescinds the value of some tax benefits. This year, many affluent taxpayers will have higher income because of new limits on exemptions and deductions. But this higher income will also help lower their alternative minimum tax.

As a result, many people paying AMT won't owe much more in 2013—unless they have investment income subject to the 3.8% tax.

"This brand-new tax is independent of most other provisions in the code," says David Kautter, a CPA at the Kogod Tax Center at American University. He gives an example, using figures from President Barack Obama and his wife Michelle's 2012 tax returns and a calculator from the nonpartisan Tax Policy Center in Washington.

Last year, the Obamas had gross income of about $662,000 and owed federal income tax of about $108,000. Under 2013 law, Mr. and Mrs. Obama would lose more than $25,000 of their deductions and exemptions, but their AMT would also fall by about 40%.

The upshot: They would owe about the same income tax as they did in 2012.

However, less than 2% of the Obamas' 2012 income was from investments. If half of their income had been from dividends, interest and capital gains, then the Obamas' 2013 income-tax bill would rise by at least $11,000 because of the 3.8% tax, says Mr. Kautter.

Given the tax code's many quirks, individual results will vary. To find out how the new tax will affect you, check out the Tax Policy Center's free online tool at calculator.taxpolicycenter.org . Users can plug in numbers from 2012 returns—or any numbers—and get a side-by-side comparison of taxes for 2012 and 2013, detailing which elements will change.

Congress and the Internal Revenue Service have designed the 3.8% tax to cast a wide net. (See box on this page.) But there are exceptions, plus strategies for minimizing the hit. Here are steps to consider.

Minimize your adjusted gross income. The trigger for the 3.8% tax is $250,000 of adjusted gross income for joint filers ($200,000 for singles). Only net investment income above that is taxed.

Adjusted gross income, or AGI, is the number at the bottom of the front page of Form 1040. It includes certain adjustments to income but not itemized deductions, such as charitable donations, mortgage interest and state taxes.

So if a couple has $245,000 of AGI, they wouldn't owe the tax, even if all of it is investment income. But if they have $255,000, they would owe 3.8% of $5,000.

What reduces AGI? Among other items: deductible contributions to tax-favored retirement plans such as 401(k)s, individual retirement accounts or pensions; a charitable contribution of IRA assets by taxpayers 70½ or older; moving expenses; deferred compensation; and capital losses up to $3,000 deducted against ordinary income.

Rearrange your assets. The new tax is even more reason to move income-generating investments such as high-yield bonds or high-turnover mutual funds into tax-sheltered accounts such as IRAs, says Eric Lewis, a principal at Bedrock Capital Management, a financial-planning firm in Los Altos, Calif.

This advice also applies to real-estate investment trusts, he says, because they generate "nonqualified" dividends taxed at ordinary rates. For taxable accounts, he favors tax-free municipal bonds, which aren't subject to the new tax.

Time income if possible. Say a single investor with $150,000 of AGI wants to sell stock with $100,000 in long-term gains. If he sells it all at once, he will owe $1,900 due to the new tax. But if he sells half his stake on Dec. 31 and the other half on Jan. 1, there's no tax.

Lower earners who can foresee a windfall will often benefit from planning, notes Mr. Lewis. If a couple routinely has $125,000 of income but expects a $300,000 gain from a one-time asset sale, they would owe $2,850 in the new tax. "Good planning can probably avoid it," he says.

Options include an installment sale that spreads payments over a number of years or a "like-kind" exchange, a tactic in which an investor swaps assets instead of selling them, says Kogod's Mr. Kautter.

Harvest losses. The new tax applies to "net" investment income, so investors can reduce their capital gains by subtracting capital losses. One of the tax code's great benefits is that losses on one asset can offset gains from another—and excess losses can be carried over for use in the future.

Don't fret about your house—in most cases. The new tax applies to gains on the sale of a principal residence, but it probably won't matter for most people. That's because sellers can reduce their gain by the purchase price of the house, plus capital improvements, plus $500,000 per couple (or $250,000 for singles). Only gains above that amount are subject to the tax, assuming the sellers exceed the income thresholds.

Say a couple bought a house for $300,000 in 1990 and paid $100,000 for an addition in 1998. This year they sell it for $850,000. The gain in the house would be $450,000, which would be fully covered by the $500,000 exclusion.

Know how retirement income helps—and hurts. Taxable payments from pension plans, regular IRAs and Social Security aren't subject to the 3.8% tax. But such income raises AGI in a way that can expose other investment income to the tax.

For example, a couple with $290,000 of taxable income from IRAs and Social Security wouldn't owe any 3.8% tax—but that situation is unusual. If $100,000 of their income came instead from dividends, interest and capital gains, then $40,000 would be subject to the 3.8% tax, because they have that much investment income above $250,000.

For this reason, the "best" income is a qualified Roth IRA payout. The payout doesn't raise income and isn't taxable. An added bonus: It doesn't help raise Medicare premiums or tax on Social Security payments.

Consider Roth IRA conversions. Full income taxes are due on the conversion of regular IRA assets to Roth accounts, but such shifts can make sense for taxpayers who expect their income to rise above the $250,000 or $200,000 thresholds later in retirement.

"If income is lower now because people are waiting until 70 to take Social Security and IRA withdrawals, we consider Roth conversions," says Mr. Lewis.

Understand what's exempt. Tax-free municipal-bond interest isn't subject to the 3.8% tax. The income from taxable Build America Bonds is subject to it, however, as would be capital gains from trading munis.

Life-insurance proceeds, gifts and inheritances are also not subject to the tax, nor are appreciated assets donated to charity.

Another exception: income from real-estate activities earned by "qualified professionals." Such people must spend a minimum of 750 hours actively managing real estate (not just arranging financing), and that must equal more than half their working hours, says Stewart Karlinsky, a CPA and professor emeritus at San Jose State University in California.

Owners of Subchapter S firms might also escape the tax if they are actively involved in the business. There are various tests of active involvement, but the most common is working at least 500 hours a year. "This is a good reason to have family members work in a family-owned business," says Mr. Karlinsky.

Finally, active partners don't owe the 3.8% tax on their share of a partnership's business income, unless it's from trading financial instruments or commodities, says Monte Jackel, a tax expert in Silver Spring, Md.

Check in with your hedge fund. Tax strategist Robert Gordon of Twenty-First Securities in New York suggests that hedge-fund investors ask managers about possible changes that could pose problems.

The 3.8% tax is prompting some managers to consider taking their own incentive pay as a fee rather than as "carried interest" subject to the 3.8% tax. While this could help the managers, it could put investors at a disadvantage by giving them large amounts of nondeductible investment expenses, says Mr. Gordon.

Hedge funds with "trader" tax status could face a worse problem: Current rules don't allow the funds to offset gains with losses before paying the 3.8% tax. "A trader fund could actually have a loss, and investors would still owe the new tax," he says.

Go offshore. The 3.8% tax gives wealthy taxpayers yet another reason to invest legally through offshore funds in the Cayman Islands and elsewhere, says David Miller, an attorney at Cadwalader, Wickersham & Taft in New York.

Using a "blocker" corporation allows investors to delay the payment of the 3.8% tax by letting income build up in the offshore fund. This strategy can also reduce tax when paid, because the tax would be owed on net rather than gross income.

Know what's different for trusts. The 3.8% tax applies at a much lower threshold for trusts—$11,950 of income instead of $250,000 or $200,000. But that's only for investment income retained in the trust. If the income is paid out to beneficiaries, their own tax rates apply.

Hold investments until death. As with the capital-gains tax, the new levy doesn't apply to assets held at death.

Such assets are marked up to their current value and become part of an estate. The current federal estate-tax exemption is a generous $5.25 million per individual this year (and indexed for inflation), so holding highly appreciated assets until death could be a smart move.

For example, say an elderly woman owns a beach property now worth $1 million that was valued at $50,000 when she inherited it in the mid-1970s. If it's sold while she's alive, she would owe as much as $36,100 due to the 3.8% tax, plus capital-gains tax. If she still owns the property at death, however, neither tax will apply.