If you’re a real estate seller who’s an investor, you’re likely thinking about your capital gains, but you need to know about a tax hiding in the background that can creep into your profit and erode it little by little: the Net Investment Income Tax (NIIT).
How do I avoid the 3.8 percent Net Investment Income Tax when selling rental property and realizing a $1 million profit? You’ve owned the property for 10 years, and you were the only one to maintain it, handle the tenants, and make every fix and upgrade. And then to be told you may have to pay an additional $3.8% in taxes?
This 3.8% may not sound so bad at first glance, but when you’re considering the sale of real estate in the six- or seven-figures, they can quickly add up. A $1 million profit, for example, can set you back an additional $38,000 in tax, unless you take action.
We will discuss three proven strategies to avoid NIIT on rental property sale in this article, such as the requirements you need to meet, and walk you through how real estate professional status, short-term rentals, and self-rentals can be utilized to reduce exposure and maximize your gain lawfully.
We will also be discussing tax strategies for selling rental property, which can decrease exposure and maximize your gain.
But let’s get to the point about what the NIIT is and why it’s more important than ever.
What Is the Net Investment Income Tax (NIIT)?
The Net Investment Income Tax was established by the Affordable Care Act of 2013 as the source of funds for the expansion of Medicare. It is a 3.8% surtax on certain types of passive income, most capital gains, and most rental income, accrued by real estate investors and high-income earners.
You must pay NIIT if your modified adjusted gross income (MAGI) is more than:
- $200,000 for single filers
- $250,000 if married and filing jointly
- $125,000 for joint filing if married
So, is rental property subject to NIIT? Yes, if you don’t consider the property a business or qualify for a critical exception under Internal Revenue Code Section 1411.
Understanding the IRS regulations on NIIT is crucial, not only for compliance but for effective tax savings planning. Therefore, when does this tax apply to a sale of property?
When Does NIIT Apply to Selling a Rental Property
Let’s say you have a rental house that you’ve owned for 10 years, and you sell it for a $1 million gain. Besides capital gains tax, you have a $38,000 NIIT hit unless you take a few precautions. That’s why clear tax strategies for selling rental property are so crucial.
Is selling a rental property subject to NIIT? Yes, if the gain is net investment income and your MAGI is above the IRS threshold.
To calculate the tax, you will have to fill out IRS Form 8960, which computes the 3.8% tax on the lesser of
- Your net investment income, or
- The degree to which your MAGI exceeds the threshold
Unless your property sale is part of a business activity, the gain will be considered passive, and therefore completely taxable under the 3.8% tax.
But perhaps your real estate business isn’t passive. Let’s talk about that next.
Real Estate Professional Status: The Golden Exemption
One of the best ways to avoid NIIT on rental property sales is by meeting the real estate professional test of the IRS.
To be eligible, you must meet the requirements under IRC §469(c)(7), including:
- Spending more than 750 hours a year on the real estate business, and
- Spend over 50% of your total working time on these types of activities.
Also, you have to establish material participation, i.e.:
- You do all the work, or
- You worked 100+ hours, and more than anyone else on the property.
Passing this test turns your rental income, and even gains on a sale, into non-passive income, effectively exempting them from net investment income tax.
These real estate professional status tax benefits can easily reduce your tax liability. They do, however, require accurate time-tracking and consistency to stand up in an audit.
Assuming you’re doing short-term rentals instead? You might have another exemption that you can use.
Short-Term Rentals and the NIIT Exemption
Short-term rentals (e.g., vacation houses or Airbnb) are another means of escaping NIIT, if managed properly.
Here’s the breakdown:
- If your property is let on a daily basis for fewer than 7 days, a tenant, or fewer than 30 days with services (i.e., food, cleaning, etc.), and you add material, then it would be classified as active business income, filed on Schedule C. That is; offering short-term rentals (e.g., Airbnb or Vrbo) with significant services often qualifies as a business activity, requiring Schedule C.
- A rental property typically becomes a Schedule C business when the owner actively operates it as a business and provides substantial services to tenants, going beyond basic property rentals.
- Providing Substantial Services: Beyond Basic Services: If you provide services beyond basic utilities, maintenance, and trash collection, you might be running a business, according to the IRS. Examples of Substantial Services: This could include things like regular housekeeping, maid service, linen service, or providing meals.
It’s worth knowing the difference between Schedule C and Schedule E short-term rental tax reporting. Schedule C is income from a business; Schedule E is still passive, unless you can show that it’s part of a business.
Either way, a short-term rental NIIT exemption would be available, based on your level of activity, and even Schedule E rentals qualify as a business if under the right scenario.
Short-lets are handy, but there is a different side that is much less observed.
Key Differences Between Schedule C and Schedule E for Rental Properties
1. Nature of Activity
Schedule C (Business): Active business with substantial services provided.
Schedule E (Rental): Passive rental activity with only basic services.
2. Reporting
Schedule C (Business): Reports profit or loss from a trade or business as a sole proprietorship.
Schedule E (Rental): Reports rental income and related expenses.
3. Self-Employment Tax
Schedule C (Business): Income is subject to self-employment tax.
Schedule E (Rental): Generally not subject to self-employment tax.
4. Passive Activity Loss Rules
Schedule C (Business): Losses may not be limited by passive activity loss rules.
Schedule E (Rental): Losses may be limited by passive activity loss rules.
Self-Rentals: A Hidden Loophole Many Overlook
What if you rent a building to your own company?
This is where the self-rental net investment income tax exemption steps in. If you own a business and rent out a building to the business, and you’re an active participant, then the rental income is considered non-passive.
That means:
- No NIIT on rent income
- Possible deductions for the company
But not if your company is a C corporation, and rules of aggregation may differ. But for most owners of S corp or LLC, this is a valid method to avoid NIIT on rental property sale and continuing rental income.
If you are a real estate dealer and rent properties held for sale in the ordinary course of business, you would also report this income and expenses on Schedule C.
Maximize Your Tax Savings Before You Sell by Planning in Advance
You cannot evade net investment income tax with a last-minute move. You must plan, record, and coordinate your activities ahead of time.
The following are some proactive things to do:
- Track your hours: Especially if you’re working towards real estate professional status
- Cluster elections together: Great if you have more than one property
- Ownership structure smartly: LLCs, S corps, and trusts each differ in their tax implications.
- Run income scenarios: Observe what a large gain does to your MAGI and activates NIIT.
- Consult with a professional tax advisor in time, especially someone who has experience in real estate taxes.
Understanding how to avoid the 3.8% net investment tax is just part of smart portfolio planning. If you want a worthwhile, tax-free exit, begin early.
Conclusion
In brief, yes, is rental property subject to NIIT? It can be. But with appropriate planning, it need not be.
By becoming a real estate professional, utilizing short-term rentals, or establishing self-rentals, you can legally avoid NIIT on rental property sales and keep more of your gain.
These aren’t loopholes; these are real options built into the tax code itself (IRC §1411) and governed by special IRS regulations. If you’ll be selling a rental property this year, don’t leave thousands on the table. Make the most of the tax code.
Need one-on-one attention? Schedule an appointment with Neil Jesani Advisors today.
