Rental income is an important source of passive income for many investors. However, rental income is also subject to taxation. One of the taxes that rental income may be subject to is the Net Investment Income Tax (NIIT). In this article, we will analyze in detail whether rental income needs to pay NIIT, the calculation method and tax rate of NIIT on rental income, and some strategies to reduce the NIIT tax burden. Getting clear on the tax rules for rental income can help investors better evaluate the after-tax returns on their real estate investments.
What is NIIT and what income is subject to NIIT?
The Net Investment Income Tax is a 3.8% tax that applies to certain net investment income of individuals, estates and trusts. It was passed as part of the Affordable Care Act in 2010. The NIIT applies if you have net investment income and also have modified adjusted gross income (MAGI) above the applicable threshold amount. For individuals, the income threshold is $200,000 for single filers and $250,000 for married couples filing jointly. So higher income investors are more likely to be subject to NIIT.
Investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and income from businesses that are passive activities to the taxpayer. All these types of investment income are subject to NIIT if the income threshold is met.
Rental income is subject to NIIT
Rental income is specifically included in the definition of net investment income under NIIT rules. So if an investor’s MAGI exceeds the threshold and they have net rental income, they will need to pay 3.8% NIIT on that rental income.
For example, suppose a married couple has $260,000 in MAGI and $50,000 in net rental income from a rental property investment. Their MAGI exceeds the $250,000 threshold for married joint filers. So they will owe NIIT of 3.8% * $50,000 = $1,900 on their rental income.
It is important for real estate investors to be aware that their rental profits can trigger the NIIT. This 3.8% tax rate is in addition to regular federal and state income taxes on rental income. The NIIT can noticeably reduce net rental yields, so investors should factor it into their return calculations.
How is NIIT calculated on rental income?
The NIIT applies to your net rental income, not gross rental income. To calculate it:
– Determine your net rental income: Rental income minus rental expenses = Net rental income
– If you have a positive net rental income number, and your MAGI exceeds the threshold, then the NIIT applies. The NIIT is 3.8% of your net rental income amount.
So the calculation is straightforward – take your net profit from renting out a property, and apply a 3.8% tax to it. Properly tracking rental income and expenses is important to determine the final NIIT amount.
Deductions like depreciation and amortization lower your net rental income, which in turn can reduce your exposure to NIIT. Grouping rental properties into a separate LLC can also potentially reduce NIIT compared to reporting them individually.
Strategies to reduce rental income NIIT
Here are some strategies investors can consider to reduce their NIIT burden on rental income:
– Use a cost segregation study to maximize depreciation deductions and lower net income.
– Expense all possible rental costs in the year they occur to lower net taxable income.
– Contribute more to tax-deferred retirement plans like 401(k)s to reduce MAGI below the NIIT threshold.
– Keep accurate records of time spent on rental activities to qualify as a Real Estate Professional – rental income may then be exempt from NIIT.
– Place rental properties into a separate LLC taxed as an S-corp – pay yourself a reasonable salary and distribute remaining profits as lower-taxed dividends.
– Use an IRA LLC to own rental property and avoid UBIT taxes.
– Work with a tax advisor to model different scenarios and legal structures to minimize total taxes.
In summary, rental income is subject to the 3.8% Net Investment Income Tax if your MAGI exceeds $200,000 or $250,000. Careful tracking of income and expenses is key to calculate NIIT accurately. Investors should understand the tax implications and utilize strategies to reduce the NIIT tax burden on their rental profits where possible.