Net Investment Income Tax and Depreciation

Some owners face an additional tax on investment income known as the net investment income tax. It can interact with depreciation in two ways: depreciation reduces rental income that may be subject to the tax, and depreciation recapture on sale increases gain that may be subject to it. This page introduces the interaction in general terms. Rates and thresholds should be verified.

The tax in brief

The net investment income tax is generally a 3.8 percent tax on the lesser of net investment income or the amount by which modified adjusted gross income exceeds a threshold that depends on filing status. The thresholds are set by statute and are not indexed for inflation as generally understood, so verify.

What counts as net investment income

Net investment income generally includes interest, dividends, capital gains, and rental and royalty income, unless the income is derived in the ordinary course of a trade or business that is not a passive activity or a trade in financial instruments. Net investment income is reduced by properly allocable deductions, which include depreciation.

Rental income

Rental income is generally net investment income unless the rental activity is a trade or business, and for the exception, the trade or business must be nonpassive for that purpose. For real estate professionals who materially participate, rental income may be treated as derived from a trade or business, so it may not be net investment income. This is a detailed area and depends on facts and elections. Ask your preparer. See Real Estate Professional Status and Study Decisions.

Effect of depreciation on rental income

If rental income is subject to the tax, then depreciation deductions reduce net investment income and therefore reduce the tax base for that year. Accelerated depreciation from a study can increase that effect in the study year. It also affects modified adjusted gross income, which may put you below the threshold in some cases.

Gain on sale

Gain from the sale of rental property may be net investment income if the property was held in a passive rental or in a trade or business that is passive for the purposes. Recapture amounts are part of the gain. So accelerated depreciation can increase the taxable gain that is subject to the tax on sale, as it lowers basis. Both federal income tax and this tax could apply to the gain, subject to exceptions.

Timing effects

Deductions taken earlier reduce the base in early years. Gain recognized later increases the base later. The net effect depends on your income in each period and on whether you are above the threshold in those years.

Short-term rentals and the tax

Whether short-term rental income is subject to the tax depends on classification and participation. Ask your preparer. See The Short-Term Rental Rules Explained Carefully.

Entities

The tax applies at the individual level for pass-through income. Partners and shareholders apply the rules in light of their own participation.

Practical use in a decision

When you model a sale case, include the tax. Even though the details are complex, ask your preparer whether the tax is likely to apply to you and how it would change the recapture analysis. See Hypothetical: Sale and Recapture After a Study.

Not covered here

State taxes, which vary, and the tax's interactions with trusts and estates, which are their own subject.

Illustrative effect in words

Suppose an owner with income above the threshold has rental income before depreciation and a study reduces net rental income through added depreciation. The net investment income subject to the tax is lower in that year by the amount of the deduction, to the extent it is properly allocable. The tax saved is a modest percentage of the deduction. Later, on sale, the gain that includes recapture is net investment income, which could produce the tax on a larger gain. The percentage is the same, so the effect is a timing effect as with the income tax, plus differences in the income levels of each year.

Who may be outside the tax

Owners whose rental activity qualifies as a trade or business and who are not passive in it may treat the income differently. Owners with income below the threshold are not subject to the tax. Owners whose income fluctuates may be over the threshold in the sale year but not in earlier years.

What to ask

Ask whether the tax applies to you now, whether it is likely to apply in the sale year, and how the rental activity is characterized for this purpose. Ask how the tax interacts with any exchange or installment sale. Ask whether any state analog exists.

A note on precision

Because thresholds and definitions are technical, this page is only an orientation. Verify details with your preparer.

Planning context

The tax is one of several taxes in the sale picture. When you evaluate a study, consider federal income tax, this tax, and state tax together, using current rates verified with your preparer.

Next steps

Read Depreciation Recapture on Sale: What Comes Back to see how gain is categorized.