Is Rental Income Subject to Net Investment Income Tax?

The Net Investment Income Tax (NIIT) is a consideration for taxpayers with investment income, including rental income. This tax aims to generate revenue for healthcare reform. Understanding its application to rental activities is important for financial planning.

Basics of the Net Investment Income Tax

The Net Investment Income Tax (NIIT) is a 3.8% tax applied to certain investment income. It targets high-income individuals, estates, and trusts.

Applicability of the NIIT is tied to specific Modified Adjusted Gross Income (MAGI) thresholds. For individuals, the tax applies if MAGI exceeds $250,000 for married filing jointly or as a qualifying surviving spouse, $125,000 for married filing separately, and $200,000 for single or head of household filers. For estates and trusts, the NIIT applies if their undistributed net investment income and adjusted gross income (AGI) exceed the dollar amount at which the highest tax bracket begins, which was $15,650 in 2025.

Net investment income includes passive income such as taxable interest, dividends, annuities, royalties, and capital gains from the sale of property like stocks, bonds, mutual funds, and real estate. Income from a trade or business considered a passive activity is also subject to the NIIT.

Certain income sources are excluded from net investment income. Wages, unemployment compensation, alimony, and most self-employment income are not considered net investment income. Gains from the sale of a personal residence excluded from gross income for regular income tax purposes, and tax-exempt interest, are also exempt from NIIT.

Rental Income Classification for NIIT Purposes

Rental income is presumed to be passive activity income, meaning it is included in net investment income subject to the NIIT. This default classification holds unless specific conditions reclassify the activity as non-passive. The distinction between passive and non-passive is important because only passive income is subject to the NIIT.

The concept of “material participation” is key to reclassifying rental activities from passive to non-passive. Material participation signifies involvement in an activity’s operations on a regular, continuous, and substantial basis. The IRS provides seven tests to determine if a taxpayer materially participates. Meeting one of these tests can change the character of the income.

One common material participation test involves participating in the activity for more than 500 hours during the tax year. Another test is met if the individual’s participation constitutes substantially all of the participation in the activity by anyone, including non-owners. A third test applies if the individual participates for more than 100 hours, and their participation is not less than that of any other individual. Other tests consider significant participation activities, participation over a historical period (e.g., five of the preceding ten years), or personal service activities.

Becoming a “Real Estate Professional” (REP) is another way to avoid the NIIT on rental income. To qualify as a REP, an individual must meet two criteria: more than half of the personal services performed in all trades or businesses during the tax year must be in real property trades or businesses, and the individual must perform more than 750 hours of services in real property trades or businesses in which they materially participate. If a taxpayer qualifies as a real estate professional and materially participates in their rental activities, their rental income is treated as business income rather than investment income, potentially exempting it from the NIIT.

Even for real estate professionals, material participation in each rental activity or a properly grouped set of activities is necessary to treat the income as non-passive. For example, if a real estate professional does not materially participate in a specific rental property, its income could still be considered passive and subject to NIIT. Detailed record-keeping of hours spent and activities performed is important.

Certain rental scenarios have specific NIIT implications. Short-term rentals, where the average customer stay is seven days or less, can be treated as a business rather than a rental activity, potentially exempting them from NIIT if there is material participation. However, time spent on short-term rentals may not count towards the 750 hours for real estate professional status if they are not considered a “rental activity” for that purpose. Rental of property to a business in which the individual materially participates (self-rentals) may also be excluded from net investment income.

Computing and Reporting Net Investment Income Tax

Calculating the Net Investment Income Tax (NIIT) involves a comparison of two amounts. The tax is levied on the lesser of a taxpayer’s net investment income or the amount by which their Modified Adjusted Gross Income (MAGI) exceeds the applicable threshold. This means a taxpayer pays NIIT only on the portion of their income that exceeds the threshold and is also considered net investment income.

To compute the amount subject to NIIT, a taxpayer first determines their total net investment income. This includes rental and royalty income, interest, dividends, and capital gains, reduced by deductions allocable to this investment income. Deductions include investment expenses, certain state and local taxes on investment income, and passive activity losses.

Next, the taxpayer calculates their Modified Adjusted Gross Income (MAGI). For most individuals, MAGI is their Adjusted Gross Income (AGI) for regular income tax purposes, with certain additions like excluded foreign earned income. If no foreign earned income is excluded, AGI and MAGI are the same for NIIT purposes.

Once both net investment income and MAGI are determined, the taxpayer compares their MAGI to the statutory income thresholds for their filing status. For example, a single filer with a MAGI of $250,000, exceeding the $200,000 threshold by $50,000, would compare this $50,000 excess to their net investment income. If their net investment income was $150,000, the NIIT would apply to the lesser amount, which is $50,000.

The NIIT is reported on IRS Form 8960, “Net Investment Income Tax—Individuals, Estates, and Trusts.” This form guides taxpayers through the calculation, starting with sources of investment income and allowing for deductions. The final calculated NIIT amount from Form 8960 is then included on the taxpayer’s main income tax return, Form 1040.

Rental income, which is reported on Schedule E (Supplemental Income and Loss), feeds into the calculations on Form 8960. If the rental activity is considered passive and generates net income, that income will flow from Schedule E to Form 8960 to be included in net investment income. Maintaining detailed records of rental income and expenses is important for accurate NIIT computation and reporting.