Is a Section 1231 Gain Subject to Net Income Investment Tax (NIIT)?

Posted Oct 18, 2021


What Is the Net Income Investment Tax?

The Net Income Investment tax NIIT is contained in Section 1411 of the Internal Revenue Code and applies a tax rate of 3.8 percent to the net investment income of individuals, estates, and trusts that have income above specific thresholds. It began in the 2013 tax year and affects higher-income earners. The NIIT includes income from these sources:

  •       Short or long term capital gains
  •       Interest
  •       Rental or royalty income
  •       Passive business income
  •       Income from a business that is involved in trading financial instruments or commodities
  •       Nonqualified annuity payments

But not these:

  •       Salary and wages
  •       Social Security benefits or Veteran’s Retirement benefits
  •       Unemployment compensation
  •       Life insurance proceeds
  •       Income from a non passive business
  •       Tax-exempt interest
  •       Tax-exempt capital gains
  •       Deferred compensation from a tax-exempt organization
  •       Retirement or pension plan payments

The determination of whether you must pay the NIIT requires a calculation of your Modified Adjusted Gross Income (MAGI), which the IRS uses as a threshold for NIIT payment eligibility. For example, a single taxpayer with a MAGI of $200,000 is subject to the tax, while a couple married and filing jointly needs a combined MAGI of $250,000. The MAGI calculation is your adjusted gross income minus adjustments that include retirement account contributions, education expenses, student loan interest, self-employment taxes, and moving expenses.

What Are Section 1231 Gains?

The IRS defines Section 1231 gains as coming from the disposition of depreciable assets held by your business for longer than one year. Therefore, the growth may be taxed at the lower capital gains rate instead of the ordinary income rate.  Any assets used in your business that you hold for less than a year do not qualify for Section 1231 treatment when sold. Also, any loss that results from the sale of such assets is treated as an ordinary loss.

What Assets Might Qualify as Section 1231 Gains?

Examples of qualifying property include:

  •       Buildings
  •       Machinery
  •       Timber and other resources
  •       Crops
  •       Livestock

Assets that are excluded include:

  •       Poultry
  •       Patents and inventions
  •       Inventory

Section 1231 assets are sometimes said to get tax treatment that offers the "best of both worlds" since a gain is treated as a capital gain while a loss is treated as an ordinary income loss. Why is this an advantage? It is because capital loss deductions are limited to $3,000 per year, while regular income losses can be fully deducted against ordinary income in the year incurred.

What Is Passive Business Income?

For the gain from the sale of a Section 1231 asset to be excluded from the NIIT, it needs to be generated by a business that is not passive. The IRS defines passive business activities as those in which the taxpayer does not actively participate on a regular, continuous, and substantial basis. One example of active participation is when a taxpayer creates the company, sells products, hires employees, and directs activities. Individuals with less robust involvement in the company operations should seek advice from a professional to determine whether they are actively involved in the business.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Learn Ways to Help Reduce or Defer Taxes

Learn Tax-Deferred Strategies
Download eBook


Learn Tax-Deferred Strategies

Learn Ways to Help Reduce or Defer Taxes

Discover ways to potentially grow wealth by managing taxes.

By providing your email and phone number, you are opting to receive communications from Realized. If you receive a text message and choose to stop receiving further messages, reply STOP to immediately unsubscribe. Msg & Data rates may apply. To manage receiving emails from Realized visit the Manage Preferences link in any email received.