The net investment income tax (NIIT) is an important consideration for landlords when selling a rental property in the US. This 3.8% surtax applies to certain net investment income from interest, dividends, annuities, royalties, rents, and capital gains when a taxpayer’s income exceeds certain thresholds. For landlords, understanding how the NIIT applies to rental property sales is crucial for proper tax planning and optimization. This article provides an overview of key NIIT concepts and strategies landlords can use to potentially minimize NIIT exposure when selling rental properties.
An Overview of NIIT Basics for Rental Property Sales
The NIIT was introduced under the Affordable Care Act in 2013 and applies at a rate of 3.8% on top of capital gains taxes owed on investment income. For individuals, the NIIT kicks in when modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for married couples filing jointly. Importantly, capital gains from selling real estate count as part of MAGI for determining NIIT thresholds. So if selling an investment property pushes a landlord’s income over the limits, NIIT will apply to the capital gains.
For rental property sales, NIIT applies to the lesser of net capital gain attributable to the property or the landlord’s net investment income. Net investment income includes capital gains plus other investment income like interest, dividends, and passive business income. However, it does not include Social Security benefits, tax-exempt municipal bond interest, self-employment income, or distributions from qualified retirement plans. The NIIT does not replace capital gains taxes but acts as an additional layer on top of capital gains owed. Proper planning around capital gains thresholds and utilizing strategies like 1031 exchanges can potentially minimize exposure.
Leveraging Depreciation Recapture to Lower NIIT
An important concept for minimizing NIIT on rental property sales is understanding depreciation recapture. When landlords deduct depreciation expenses on rental properties each year, the full amount of depreciation is recaptured (taxed as ordinary income) upon sale. Appreciation gains above the depreciated tax basis are taxed as capital gains.
Because depreciation recapture is treated as ordinary income, it does not count as net investment income for NIIT purposes. By maximizing depreciation deductions over the years, landlords can lower the capital gain portion subject to NIIT. For example, a landlord purchased a property for $100,000 and deducted $30,000 in depreciation over 10 years. If the property sells for $200,000, the $30,000 depreciation is recaptured as ordinary income. The capital gain is only $70,000 ($200,000 sale price – $100,000 original basis – $30,000 depreciation recapture). With proper tax planning, the NIIT exposure is minimized.
Proactive Tax Planning to Reduce NIIT Burden
Savvy real estate investors take a proactive approach to reducing NIIT burden when planning an investment property sale. Here are some key strategies to consider:
– Harvest capital losses to offset gains – By realizing capital losses from other investments, landlords can offset capital gains and lower net investment income.
– Contribute to retirement accounts – Contributing pre-tax dollars to accounts like 401(k)s and IRAs can reduce MAGI used for NIIT thresholds.
– Utilize an installment sale – Spreading gains over multiple years results in smaller chunks subject to NIIT each year.
– Hold property for over 1 year – Gains on assets held over 1 year are subject to lower capital gains rates.
– 1031 exchange into opportunity zones – Deferral combined with potential partial exclusion makes opportunity zones attractive.
– Keep income below thresholds – Consider timing of sale in relation to other income sources to avoid crossing key NIIT thresholds.
The NIIT creates another layer of complexity for real estate investors to navigate. But armed with an understanding of how the NIIT applies, investors can employ strategies to potentially reduce exposure and keep more profits when selling appreciated investment properties.
The NIIT can take a significant bite out of profits when selling rental properties. But utilizing depreciation recapture and proactive planning around capital gains can help investors minimize additional tax burdens. Work closely with a knowledgeable tax professional to implement smart NIIT strategies.