The net investment income tax (NIIT) is a 3.8 percent tax that taxpayers pay in addition to what they pay according to the tax table rates when they own rental property.
You pay the NIIT only if
- your modified adjusted gross income (MAGI) exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly ($125,000 for married couples filing separately), and
- you have net investment income.
Your MAGI for NIIT purposes is likely the same as your adjusted gross income (AGI), which equals your gross income less any above-the-line deductions. The tax code modifies the NIIT AGI only for certain U.S. citizens or residents who live abroad.
You pay the 3.8 percent NIIT on the lesser of
- your net investment income, or
- the amount your MAGI exceeds the applicable $200,000/$250,000 threshold.
There are 3 exceptions:
Exemption 1: Real Estate Professionals
The tax code defines the real estate professional. To qualify as a real estate professional, either you or your spouse (if you file jointly) must spend (1) over 50 percent of your work time in a real estate business or businesses and (2) over 750 hours working in real estate businesses during the year. When it comes to rental property, tax-law-defined real estate professionals earn supreme status because they
- deduct their losses from non-rental income, and
- most likely qualify to have their profits escape the NIIT.
Consequently, if a taxpayer could achieve tax-law-defined real estate professional status, the taxpayer has the best of all tax worlds: deductible losses and most likely profits that escape the NIIT when your rental activity qualifies as a business for tax purposes.
Material Participation in Rental Activity
In addition to being a real estate professional, you must materially participate in your rental activity to deduct your losses or qualify for the NIIT exemption. There are seven ways to establish material participation. The two most common are
- doing all the work on the rental, or
- working more than 100 hours on the rental and that’s more than any other individual works on the rental.
Rental Activity as a Business
There is one more hoop you must jump through for the NIIT exemption: Your rental activity must qualify as a business, not a mere investment activity, under IRC Section 162. Most rental activities are businesses even though they are reported on Schedule E.
Exemption 2: Short-Term Rentals
You have a short-term rental when the average tenant stay is seven days or less, or when it is not more than 30 days and you provide services. The short-term rental is exempt from the tax-law-defined real estate professional rules. To deduct your losses on a short-term rental, you need to materially participate in the property.
You are subject to the NIIT on your short-term rental if (1) you materially participate and (2) the rental is a tax-code-defined business.
Exemption 3: Self-Rentals
Passive income from rental property that would otherwise be subject to the NIIT is recharacterized as non-passive if you rent the property to a business in which you materially participate. In other words, income from self-rentals is not included in net investment income.
Taxpayers should note that:
- The often-overlooked NIIT is a 3.8 percent tax on taxpayers with an AGI over $200,000 if single, or $250,000 if married filing jointly. The tax is paid on the lesser of net investment income or the amount AGI exceeds the threshold.
- Net investment income includes income from real estate rentals, but not from rental businesses in which you materially participate.
- Tax-law-defined real estate professionals are exempt from the NIIT so long as their rental activity qualifies as a business activity.
- Short-term rentals reported on Schedule C of your Form 1040 trigger the self-employment tax but are exempt from the NIIT if you materially participate in the rentals.
- Short-term rentals reported on Schedule E can qualify as businesses, and if so, they escape the NIIT if you materially participate.
- Self-rentals of your rental property to a business you own and in which you materially participate are exempt from the NIIT.