What is Net Investment Income Tax?
When most investors think about the benefits of a 1031 Exchange, they focus on deferring capital gains taxes. However, a properly structured exchange can also help defer other taxes — including the Net Investment Income Tax (NIIT), a lesser-known tax that applies to certain high-income individuals and trusts.
This article explains what the NIIT is, who it affects, and how it interacts with Section 1031 of the Internal Revenue Code.
What Is the Net Investment Income Tax (NIIT)?
The Net Investment Income Tax is a 3.8% surtax established under the Health Care and Education Reconciliation Act of 2010. It applies to individuals, estates, and trusts with income above specific thresholds.
The NIIT is assessed on net investment income, which generally includes:
Interest
Dividends
Capital gains
Rental and royalty income
Passive income from businesses
However, active income (such as wages or self-employment earnings) is not subject to this tax.
Who Is Subject to the NIIT?
The NIIT applies when a taxpayer’s modified adjusted gross income (MAGI) exceeds the following thresholds:
$250,000 for married couples filing jointly
$200,000 for single filers or heads of household
$125,000 for married individuals filing separately
If your MAGI exceeds these limits, the 3.8% NIIT is applied to the lesser of:
Your net investment income, or
The amount by which your MAGI exceeds the applicable threshold.
How the NIIT Affects Real Estate Investors
For real estate investors, rental income and capital gains from the sale of investment property typically count as net investment income — unless the taxpayer qualifies as a real estate professional under IRS rules and materially participates in the activity.
This means that if you sell an investment property without a 1031 Exchange, your capital gain could be subject to:
Federal capital gains tax,
Depreciation recapture tax,
State income tax (if applicable), and
The 3.8% NIIT.
That’s where a 1031 Exchange can make a difference.
How a 1031 Exchange Impacts the NIIT
When properly executed, a 1031 Exchange allows you to defer recognition of capital gain, which also defers the Net Investment Income Tax that would otherwise apply to that gain.
Because the NIIT is triggered by realized investment income, deferring gain through an exchange means the related NIIT is not currently assessed. The deferred gain — and its associated tax — only become due if the taxpayer eventually sells without completing another qualifying exchange.
It’s important to note, however, that income generated by replacement property (such as rental income) may still be subject to NIIT if the taxpayer exceeds the income thresholds and is not a material participant.
Example:
Suppose an investor sells a commercial property and realizes a $500,000 gain.
Without a 1031 Exchange, that gain could trigger capital gains taxes plus an additional 3.8% NIIT if the investor’s income exceeds the threshold.
With a properly structured 1031 Exchange, both the capital gain and NIIT related to that gain are deferred — preserving more capital for reinvestment.
Why the NIIT Matters for Real Estate Investors
The Net Investment Income Tax (NIIT) is an additional 3.8% surtax that applies to high-income earners’ investment income, including gains from real estate. Through a 1031 Exchange, investors can defer not only capital gains and depreciation recapture taxes but also the NIIT tied to those gains — allowing them to reinvest more effectively.
Disclaimer
This article is intended for informational purposes only and should not be considered legal or tax advice. Always consult a Qualified Intermediary or tax professional before completing a 1031 Exchange or determining NIIT liability.
