Strategies to Reduce the Net Investment Income Tax

The Net Investment Income Tax (NIIT) is a 3.8% tax that operates in addition to other taxes, like capital gains tax. It affects individuals, estates, and trusts with both net investment income and a modified adjusted gross income (MAGI) above certain thresholds.

Understanding the NIIT Calculation

The NIIT is levied on the lesser of two amounts: your total net investment income (NII) for the year, or the amount by which your Modified Adjusted Gross Income (MAGI) surpasses the threshold for your filing status. This means you will not owe the tax if your MAGI is below the applicable threshold, regardless of your investment income.

The MAGI thresholds depend on your filing status. The threshold is $250,000 for Married Filing Jointly or a Qualifying Surviving Spouse, $200,000 for Single or Head of Household filers, and $125,000 for Married Filing Separately. These thresholds are not indexed for inflation, so more taxpayers may become subject to the NIIT over time.

Net Investment Income includes earnings like interest, dividends, capital gains, non-qualified annuities, and income from rental, royalty, or passive business activities. The calculation of NII allows for the deduction of related expenses, such as investment advisory fees, brokerage fees, and state and local income taxes attributable to the investment income.

Certain income is excluded from NII, including wages, self-employment income, and distributions from qualified retirement plans like 401(k)s and IRAs. Interest from federally tax-exempt municipal bonds is also excluded. Additionally, the tax-exempt gain from the sale of a principal residence, up to $250,000 for single filers and $500,000 for joint filers, is not part of NII.

Strategies to Reduce Modified Adjusted Gross Income

One way to avoid the NIIT is to lower your MAGI below the threshold for your filing status, which can be done by making tax-deductible contributions to certain accounts.

Maximizing contributions to pre-tax retirement accounts like a traditional 401(k) or a traditional IRA can lower your MAGI. These contributions are made with pre-tax dollars, reducing your gross income. Self-employed individuals can achieve similar benefits by contributing to a SEP IRA.

Contributing to a Health Savings Account (HSA) is another way to reduce MAGI. If you have a high-deductible health plan, you can make pre-tax contributions to an HSA, which lowers your adjusted gross income.

Individuals age 70½ or older can make a Qualified Charitable Distribution (QCD) to lower their income. This strategy allows a donation of up to $108,000 in 2025 directly from a traditional IRA to a qualified charity. The donated amount is excluded from your gross income, which lowers your MAGI.

Strategies to Lower Net Investment Income

If you cannot lower your MAGI enough, the next approach is to reduce your Net Investment Income (NII). Lowering your NII can directly reduce or eliminate the tax owed.

Tax-loss harvesting involves selling investments that have decreased in value to realize a capital loss. These capital losses can then be used to offset capital gains you have realized from selling other profitable assets. This netting of gains and losses reduces your overall capital gain income included in NII.

Investing in municipal bonds can lower your NII. The interest paid by these bonds is exempt from federal income tax and is also excluded from the NII calculation. Shifting a portion of a portfolio into these bonds reduces your taxable interest.

Gifting appreciated assets like stocks can remove future taxable gains from your portfolio. You can gift them to a family member in a lower tax bracket or donate them directly to a qualified charity. Donating to a charity allows you to avoid realizing the capital gain that would otherwise be included in NII.

An installment sale can spread the capital gain from the sale of a large asset over multiple years. By receiving payments over time instead of a lump sum, you can keep your NII lower in any single year. This may keep you below the NIIT threshold or reduce the taxable amount.

Shifting investments toward growth-oriented assets instead of income-producing ones can help manage NII. High-dividend stocks generate regular income included in NII, while growth stocks defer taxes until the asset is sold. This approach gives you more control over when you recognize income.

The Qualified Small Business Stock (QSBS) rules provide another opportunity for tax savings. If you hold QSBS for more than five years, you may be able to exclude some or all of the gain from its sale from your income. This exclusion also applies for NIIT purposes, which can eliminate a large capital gain from your NII.

Advanced Strategies for Business and Real Estate Owners

Owners of rental real estate or passive business activities can avoid the NIIT by changing the income’s characterization. Passive income is included in NII, while income from an active business is not. The difference depends on whether you “materially participate” in the activity per IRS rules.

Material participation is a legal standard that requires a taxpayer to be involved in the operations of an activity on a regular, continuous, and substantial basis. The IRS provides seven tests to determine if this standard is met.

One common test is the 500-hour rule, requiring over 500 hours of participation in the activity during the tax year. Another is the “substantially all” participation rule, where your involvement is nearly all of the participation by anyone. A third test requires you to participate for more than 100 hours, as long as no one else participates more.

Real estate investors can qualify as a “real estate professional” to exempt rental income from the NIIT. To meet this classification, you must spend more than half of your professional time and over 750 hours per year in real property trades or businesses. This allows you to treat your rental income as non-passive.

Anyone relying on these material participation rules must maintain detailed and contemporaneous records. These records, such as time logs or calendars, are necessary to substantiate your hours and activities in the event of an IRS audit.