Net Investment Income Tax (NIIT): The 3.8% Surtax on Passive Income for Business Owners

NIIT rules for business owners:

1. What’s subject to NIIT (3.8%):

   • Rental income (unless the taxpayer is a real estate professional AND materially participates in each rental)
   • Interest and dividends
   • Capital gains (short-term and long-term)
   • Passive business income (business income from entities where the owner does not materially participate)
   • Annuities
   • Royalties (unless derived in the ordinary course of a trade or business where the taxpayer materially participates)

2. What’s NOT subject to NIIT:

   • Active business income (S-Corp K-1 income, partnership distributive share) where the owner materially participates
   • W-2 wages (subject to Medicare tax instead)
   • Self-employment income (subject to SE tax instead)
   • Distributions from qualified retirement plans
   • Tax-exempt interest (municipal bonds)

3. The NIIT applies to the LESSER of:

   • Net investment income, OR
   • The excess of MAGI over the threshold ($200,000 / $250,000)

4. The thresholds are NOT indexed for inflation. The $200,000 / $250,000 thresholds haven’t changed since the NIIT was enacted in 2013. More taxpayers are subject to NIIT each year as incomes rise.

5. Planning strategies:

   • Convert passive income to active income by increasing material participation (meet one of the 7 tests under Treas. Reg. 1.469-5T)
   • Accelerate deductions to reduce MAGI below the threshold
   • Time capital gains realizations to years when MAGI is lower
   • Harvest capital losses to offset capital gains
   • For rental property: qualify as a real estate professional (750+ hours, more than half of personal services)