How Does the Net Investment Income Tax Apply to Rental Real Estate?
Taxpayers should be mindful that their rental income may be subject to taxes in addition to ordinary income tax.
What is the Net Investment Income Tax?
The Net Investment Income Tax (NIIT) is a surtax that took effect in 2013. The NIIT was intended to boost tax revenue from Medicare payroll taxes on earned income by broadening its reach to unearned investment income.
Net Investment Income Tax basics
The NIIT only applies to certain high-income taxpayers. Specifically, taxpayers with adjusted gross income of more than $200,000 (single filers) or $250,000 (joint filers) are subject to the surtax on investment income that exceeds the thresholds. Note that these amounts are not indexed for inflation.
NIIT imposes a 3.8% surtax on income from investments. Investments includes portfolio income items such as interest, dividends and short-term and long-term capital gains. Royalties, rental income and business income from activities that are treated as passive are also subject to the surtax. Read my post on passive activities in rental real estate to learn more.
What about self-rentals?
It is common for recipients of rental income, which include taxpayers who own rental properties directly or through pass-through entities (partnerships, LLCs or S Corporations), to also be involved with the business operations conducted on the property. The common scenario is a business owner that also owns the real estate in which he operates. The real estate is held in a separate entity that collects rents from the operating entity. Check out my previous post on IRS rules for self-rentals to learn more.
The NIIT is intended to apply to passive investment income, rather than income generated from an active trade or business. Therefore, it should not penalize a taxpayer who separates its real estate from business operations. This was clarified in an Internal Revenue Bulletin that made it clear that, if an individual derives rental income from a business activity in which the individual is materially participating, the 3.8% tax will not apply.
Does the surtax apply to real estate professionals?
While losses from real estate activities are passive per se, the losses of a real estate professional are considered ordinary losses and available to offset other ordinary income. Net rental income is generally included in the calculation of NIIT and is therefore subject to the 3.8% surtax. There is an exception if the following three conditions are met:
- the taxpayer is a real estate professional
- the rental activity rises to the level of trade or business; and
- the taxpayer materially participates in the trade or business.
If all three of the conditions are met, the income from the rental real estate activity can be excluded from the calculation of net investment income.
What about sales of real estate?
Gains from the disposition of property (other than property held in an active trade or business) is subject to NIIT, including gain on the sale of stocks, bonds, mutual funds and real estate. The gain from the sale of rental property is also subject to NIIT unless the rental activity is part of an active trade or business.
If the real estate activity is considered a passive activity, any gain on the sale of property would generate gain that would be subject to the net investment income tax. However, if the taxpayer qualifies as a real estate professional, and the activity is considered an active trade or business, any gain on the sale of the property may be exempt from the net investment income tax. The characterization of the property for purposes of taxation of the gain on disposition is determined based on the treatment of the property during its operation.
With the 3.8% Medicare surtax on net investment income, real estate professionals should have a renewed focus on tax implications relating to their level of participation in real estate businesses.