Is Sale Of Rental Property Subject To Net Investment Income Tax?

On January 1, 2013, 26 U.S. Code § 1411 - “Imposition of Tax” went into effect, to help fund the Affordable Care Act. What this meant, in plain English (and continues to mean), is that the net investment income tax, or NIIT, is assessed on certain net investment income of individuals, estates, and trusts that demonstrate income higher than the statutory threshold amounts.

What this means, in even plainer English, is that if your net investment income is higher than specific threshold amounts, you will be assessed an NIIT of 3.8%. Is the sale of rental property subject to net investment income tax? It is. To better understand the function of the NIIT, it’s a good idea to understand the definition of net investment income.

Understanding Net Investment Income

Net Investment Income, also known as NII, is defined as the amount of income, before taxes, that comes from your investment assets. These assets can include stocks, bonds, mutual funds, loans -- and rental income. And, that income can come in the form of interest, dividends, and non-qualified annuities.

According to the IRS, here is what NII is NOT:

• Wages, unemployment compensation, social security benefits, alimony, and most self-employment income
• Gain on the sale of a personal residence, that is excluded from gross income for regular income tax purposes
• Withdrawals from retirement plans, such as 401(k)s, or traditional/Roth IRAs

This means that the rental property you might have recently sold is considered net investment income and could be subject to the NIIT. You might be thinking, quite rightfully, “what about the taxes I must pay on capital gains from that sale?” The answer to this question is, you might have to pay both capital gains taxes AND net investment income taxes on that profit, depending on the above-mentioned threshold.

Threshold Talk

Whether you owe a NIIT -- and how much you might owe -- depends on your filing status and accompanying statutory threshold amounts. Net investment income is subject to a 3.8% tax, and applies to individuals with modified gross incomes (MAGI) higher than the thresholds indicated below:

For example, let’s say you’re a single taxpayer who earns $50,000, who acquired a rental property for $200,000. That property has appreciated very nicely, and you were fortunate enough to sell it for $400,000, leaving you with $200,000 in capital gains. Between those capital gains, and your salary, your MAGI stands at $250,000. While your NII is $200,000 (which is right at that threshold), your modified gross adjusted income exceeds that threshold by $50,000. This means you’ll owe the IRS $1,900 (3.8% tax) on that $50,000.

Kicking The Can Down The Road

Examining the above, you realize that you owe both NIIT and capital gains tax on the sale of that rental property. But, if you’ve been paying attention to Realized Holdings Blogs, you also already know that you can defer the capital gains tax through a 1031 Exchange into a property (or properties) of equal or greater value. 

And, you can defer that NIIT through a 1031 exchange, as well. As is the case with deferring capital gains taxes, you will eventually owe that net investment income tax. 

The takeaway here is that, while your rental property might have nicely appreciated while you owned it, capital gains taxes, depreciation recapture, and net investment income tax can take a bite out of your profit when it comes time to sell. As such, it’s a good idea to work with your financial planner or tax advisor, to discuss appropriate tax-shelter strategies.