The net investment income tax imposes an additional 3.8% surtax on the lesser of a taxpayer's net investment income or the amount by which modified AGI exceeds a threshold ($200,000 for single filers, $250,000 for married filing jointly, $125,000 for married filing separately). The NIIT was enacted as part of the Affordable Care Act to fund Medicare and has not been repealed. It applies on top of regular income tax and capital gains tax - a taxpayer already paying 20% on long-term capital gains and the 3.8% NIIT owes a combined 23.8% on investment income above the threshold. Understanding what income is and is not NII determines whether the surtax applies and how to plan around it.
IS net investment income (subject to 3.8%): Dividends; interest; annuity income (to the extent not from a trade or business); royalties; rents from passive activities; net capital gains from sale of investment assets; passive activity income from partnerships, S-corps, and LLCs where the taxpayer does not materially participate.
IS NOT net investment income: Wages and salaries; self-employment income; active trade or business income (where the taxpayer materially participates); distributions from IRAs, 401(k)s, and other qualified retirement plans; Social Security benefits; tax-exempt interest; and gain from the sale of an active interest in a partnership or S-corporation where the taxpayer materially participated.
The threshold is not indexed for inflation. The $200,000/$250,000 thresholds have not changed since the NIIT was enacted in 2013, causing bracket creep that subjects more taxpayers to the surtax each year as incomes rise with inflation.
A common planning structure involves an S-corp owner who also owns the building the S-corp operates from, renting the building to the S-corp. Under the passive activity rules, self-rental income (rent from property rented to an activity in which the taxpayer materially participates) is re-characterized from passive income to non-passive income - which means passive losses cannot offset it. But for NIIT purposes, the self-rental re-characterization does NOT remove the rental income from net investment income. Self-rental income is still NII subject to the 3.8% surtax even though it is non-passive for §469 purposes. This creates an unexpected NIIT liability for many S-corp owner-landlords.
Qualifying as a real estate professional under §469(c)(7) removes rental income from passive classification for §469 purposes - those losses become non-passive and deductible against other income. But real estate professional status alone does NOT automatically remove rental income from NII. To avoid NIIT on rental income, a real estate professional must also materially participate in each rental activity individually. A real estate professional who qualifies at the aggregate level but does not materially participate in each individual property still has NII from the properties where participation is lacking.
Converting passive income to active income is the primary NIIT avoidance strategy. Material participation in a partnership, LLC, or S-corp removes the income from NII. Maximizing pre-tax retirement contributions reduces MAGI and can push income below the threshold. Charitable giving strategies - qualified charitable distributions from IRAs (which reduce AGI), donor-advised fund contributions, and charitable remainder trusts - can reduce MAGI below the NIIT threshold. Installment sales spread gain recognition across years, potentially keeping each year's MAGI below the threshold. Qualified opportunity zone investments defer capital gains that would otherwise be NII.