Many investors selling real estate or other high value investments are often surprised to find out that their tax liability could be subject to an extra 3.8% Surtax in addition to the applicable short-term or long-term capital gains tax rates. The Net Investment Income Tax (“NIIT”) or Medicare Tax is a 3.8% Surtax imposed by Section 1411 of the Internal Revenue Code on investment income. The NIIT went into effect on January 1, 2013 and can apply to some high-income taxpayers (individuals and trusts) who have a modified adjusted gross income (MAGI) that exceeds a certain statutory threshold.
What are the statutory thresholds amounts for the NIIT?
Individuals will owe the tax if they have Net Investment Income and have MAGI over the following thresholds:
|Filing Status||Threshold Amount|
|Married filing jointly||$250,000|
|Married filing separately||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$250,000|
“Taxpayers should be aware that these threshold amounts are not indexed for inflation. If you are an individual who is exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.”
Chart and accompanying sub-text courtesy of the IRS – for an in-depth discussion of the NIIT visit The IRS Q&A here.
Long-term capital gains and the NIIT:
A taxpayer’s corresponding federal capital gains tax rate depends on the taxpayer’s income which depending on their filing status, falls into one of three brackets and is assigned one of three corresponding rates: 0%, 15%, or 20%. The income brackets for capital gains taxes are adjusted to inflation, so they change every year unlike the thresholds for the NIIT that were discussed above.
|2021 Capital Gains Tax Rates and Brackets|
|Rate||Single Taxpayer||Married Filing Jointly||Head of Household|
|0%||$0 – $40,400||$0 – $80,800||$0 – $54,100|
|15%||$40,401 – $445,850||$80,801 – $501,600||$54,101 – $473,750|
Therefore, in practice, the NIIT may not only apply to those in the highest capital gains tax rate bracket creating a liability of 23.8%, but it could also apply to taxpayers in the high end of the middle bracket (15%) turning their potential liability into 18.8%. For example, a married couple with $350,000 in income would not make it into the 20% bracket, but a portion of their gain would be subject to an 18.8% (15% + 3.8%) rate because they fall above the NIIT threshold of $250,000. If the same married couple made $525,000 in total income, a portion of their gain would be taxed at 23.8% (20.0% + 3.8%). In addition, the NIIT may apply to gain from unrecaptured depreciation from capital assets. Unrecaptured depreciation deductions are considered part of the gain from investment real estate. Depreciation deductions subject to the NIIT would effectively be taxed at 28.8% (25% recapture rate + 3.8% NIIT).
Application: It is important to keep in mind that the tax only applies to net investment income. Net investment income includes capital gains on the sale of investment property and most rentals (property held as a passive activity). Excluded are the sale of interests in partnerships and S-Corps where the seller actively participated in the business. The sale of property held by sub-chapter C corporations and property actively used in a trade or business are not subject to the tax because there is a business use as opposed to being held for investment. However, C-Corp stock is considered a passive investment and is subject to the NIIT.
The NIIT only affects individuals, trusts and estates, and any entities with pass-through income from investments – tax partnerships or S corporations.
An exception for “Real Estate Professionals” is provided in Section 469(c)(7) “Special Rules for Taxpayers in Real Property Business” and further defined in the Regulations. See Publication 925 for more information. Among other criteria, the threshold issue is whether the “taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.” There are also separate rules for material participation in business activities See Section 469(h). Taxpayers who actively manage their real estate investments or actively participate in businesses should consult with their tax advisors to determine if the NIIT applies to their gain.
The NIIT is reported on Form 8960;
The instructions to which read in pertinent part:
Gains and losses that aren’t taken into account in computing taxable income aren’t taken into account in computing net investment income. For example, gain that isn’t taxable by reason of section 121 (sale of a principal residence) or section 1031 (like-kind exchanges) isn’t included in net investment income.
For more information please visit: The IRS resources on NIIT and on Investment Income and Expenses (Including Capital Gains and Losses).
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