Is the Sale of a Rental Property Subject to the NIIT?

The sale of a rental property can trigger the Net Investment Income Tax, or NIIT. This is a 3.8% tax on certain investment income for taxpayers whose income exceeds set amounts, and it applies in addition to regular income taxes. Whether the NIIT applies to your rental sale depends on your income level and how the rental activity is classified for tax purposes.

NIIT Applicability Thresholds

Two conditions must be met for the Net Investment Income Tax to apply. The first relates to a taxpayer’s income level, as the NIIT only affects individuals, estates, and trusts with income exceeding certain threshold amounts based on Modified Adjusted Gross Income (MAGI).

For the 2024 tax year, the MAGI thresholds are $200,000 for single or head of household filers, $250,000 for married filing jointly or qualifying widow(er)s, and $125,000 for married filing separately. These income thresholds are not indexed for inflation and do not automatically increase each year.

The second condition is that the taxpayer must have Net Investment Income (NII). NII includes income from interest, dividends, capital gains, rental and royalty income, and non-qualified annuities, while wages, Social Security, and most self-employment income are excluded. Gain from the sale of a rental property is a category of income that can be classified as NII.

Classifying Gain as Net Investment Income

The profit from selling a rental property is considered investment income for the NIIT. The tax code includes gains from the disposition of property in the definition of investment income, so the net gain from a sale is by default a component of your NII.

An exception can remove this gain from the NII calculation if it is derived from property held in a trade or business that is not a passive activity. For a rental activity to be considered a trade or business, the taxpayer’s involvement must be regular and continuous, implying active engagement in the property’s management and operations.

The primary way to classify a rental as a non-passive business is by qualifying as a “real estate professional.” To qualify, an individual must spend more than half of their personal services performed in all trades or businesses during the tax year in real property trades, such as development or property management.

Furthermore, the taxpayer must perform more than 750 hours of services during the tax year in these real property trades. If these conditions are met, the final step is to demonstrate “material participation” in the rental activity itself, which can involve participating for more than 500 hours during the year. If a taxpayer meets the real estate professional criteria and materially participates, the gain from its sale is not considered NII.

Calculating the Tax Liability

The calculation begins with determining the total gain on the sale. This is found by subtracting the property’s adjusted basis from the final sale price. The adjusted basis is the original purchase price, plus the cost of any improvements, minus the total depreciation deductions you were allowed to take while you owned the property.

You must account for depreciation, as any depreciation claimed or allowable reduces your basis, thereby increasing your potential gain. While a portion of the gain may be taxed differently for regular income tax purposes, the entire taxable gain is included when figuring your NII.

The NIIT is 3.8% of the lesser of two figures: your total Net Investment Income or the amount by which your Modified Adjusted Gross Income (MAGI) exceeds the threshold for your filing status. For example, consider a single filer with a MAGI of $240,000, which includes $50,000 of NII from a rental property sale. The excess MAGI is $40,000 ($240,000 – $200,000 threshold). Since the excess MAGI of $40,000 is less than the total NII of $50,000, the 3.8% tax is applied to $40,000, resulting in an NIIT of $1,520.

This calculation is performed and reported on IRS Form 8960, Net Investment Income Tax. If you owe the NIIT, it is added to your total tax liability on your Form 1040. Taxpayers should ensure their federal income tax withholding or estimated tax payments are sufficient to cover this additional tax to avoid potential underpayment penalties.