Depreciation Recapture and the 3.8% Net Investment Income Tax

What the NIIT is

The 3.8% Net Investment Income Tax applies to the lesser of (a) your net investment income or (b) the amount your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married filing jointly. Rental income and gains from selling rental property — including the depreciation recapture portion — are considered net investment income.

How it stacks on a rental sale

On a large sale, the total federal rate on recapture can reach 25% + 3.8% = 28.8% (if the NIIT applies), and the capital gains slice can reach 20% + 3.8% = 23.8%. Add state income tax on top and the combined rate on a rental sale can approach or exceed 35% in high-tax states.

Always factor NIIT into your net-proceeds estimate before listing a property.

One exception: active real estate

Rental income is generally passive and therefore NII. However, if you qualify as a real estate professional and the rental activity rises to the level of a trade or business, the income may not be NII. This is a complex area that requires professional guidance.

A worked example: how much the 3.8% actually costs

Numbers make the layer concrete. Say a married couple filing jointly has $150,000 of ordinary wage income and sells a rental, producing a $300,000 total gain — $120,000 of unrecaptured Section 1250 gain and $180,000 of regular long-term capital gain. Their modified AGI for the year jumps to roughly $450,000, which is $200,000 over the $250,000 MFJ threshold.

The NIIT applies to the lesser of net investment income ($300,000, essentially the whole gain) or the MAGI excess ($200,000). Here the MAGI excess is smaller, so the 3.8% applies to $200,000 — a NIIT of $7,600. That is on top of the up-to-25% on the recapture slice and the 15–20% on the capital-gain slice. Because the gain itself is what pushed MAGI over the threshold, a single large sale often drags an otherwise-below-threshold taxpayer squarely into NIIT territory in the year of sale.

Why one big sale is worse than the math suggests

The NIIT thresholds ($200,000 single, $250,000 MFJ, $125,000 married filing separately) are not indexed for inflation and have not moved since the tax took effect in 2013. Over time, more sellers cross them. More importantly, a rental gain is lumpy — it can add hundreds of thousands of dollars to MAGI in a single year, spiking you well past the threshold for that one return even if your normal income sits comfortably below it. Spreading a sale across years, where feasible, can keep more of the gain out of the NIIT base.

Strategies that reduce or defer the NIIT

Several moves can soften the hit. A 1031 exchange defers the entire gain — recapture, capital gain, and the NIIT on all of it — because no gain is recognized in the exchange year. An installment sale under Section 453 spreads the gain (and the MAGI spike) across multiple years, potentially keeping each year's MAGI closer to the threshold and shrinking the annual NIIT base. Genuine real estate professional status combined with material participation can recharacterize rental income as non-passive and, in some cases, outside NII — though gain on the sale of the property is a separate analysis. Finally, ordinary capital-loss harvesting elsewhere in your portfolio reduces net investment income directly.

What counts — and what does not — as net investment income

NII generally includes interest, dividends, capital gains, rental and royalty income, and non-qualified annuities. It does not include wages, self-employment income, Social Security, tax-exempt municipal bond interest, distributions from qualified retirement plans, or gain excluded under the Section 121 primary-residence exclusion. That last point matters for a converted home: the portion of gain sheltered by the $250,000/$500,000 exclusion is also out of the NIIT base, though the depreciation-recapture portion attributable to rental use is not excludable and remains subject to both regular tax and, potentially, the NIIT.

Reporting the NIIT and estimating it in advance

The NIIT is computed on Form 8960 and carried to your Form 1040. Because it is not withheld from a property sale, a large gain can create an underpayment penalty if you do not make a timely estimated payment in the quarter of the sale. Run the numbers before you close: estimate your full-year MAGI including the gain, apply the lesser-of test, and set aside the 3.8% (plus the regular tax) so the bill does not blindside you the following April.

Don't confuse it with the Additional Medicare Tax

Two 2013 taxes are often mixed up. The 3.8% NIIT applies to investment income — interest, dividends, rents, and capital gains. The separate 0.9% Additional Medicare Tax applies to wages and self-employment income above the same dollar thresholds. They do not overlap: a given dollar is either earned income (potentially subject to the 0.9%) or investment income (potentially subject to the 3.8%), never both. A rental sale gain is investment income, so it is the 3.8% you care about — but a high earner can owe both taxes in the same year on different income streams.

Rentals in trusts hit the NIIT far sooner

If you hold rental property inside a non-grantor trust or an estate, the NIIT threshold is dramatically lower. Instead of $250,000, the tax applies once undistributed net investment income pushes the trust's adjusted gross income over the top trust tax bracket threshold — only around $15,000, and indexed only slightly each year. A trust that sells a rental and retains the gain can owe the 3.8% on nearly the entire amount. Distributing net investment income to individual beneficiaries, who have much higher personal thresholds, is a common way to reduce the total NIIT — one more reason to coordinate a trust-held rental sale with an advisor.

The NIIT applies during the hold, not just at sale

It is easy to think of the NIIT only as a sale-year event, but net rental income earned while you hold the property is also net investment income. A high earner with several profitable rentals can owe the 3.8% on that ongoing cash flow every year, not just in the year of a sale. Depreciation helps here: because it reduces reported rental income, it shrinks both your regular tax and your NIIT base during the holding period. Grouping activities and, where available, real estate professional status can move rental income outside the NIIT — but the analysis is fact-specific and worth a professional review if your rental income is substantial.

Putting the layers together

To see the full federal picture on a recapture-heavy sale, stack the layers in order. Start with the unrecaptured Section 1250 gain at up to 25%. Add any Section 1245 ordinary recapture at your marginal rate. Add the long-term capital gain on the remaining appreciation at 0/15/20%. Then, if your MAGI clears the threshold, layer the 3.8% NIIT on top of the investment-income portions. Finally, add state income tax, which most states impose with no special recapture rate. For a high earner in a high-tax state, the combined marginal rate on the gain can land in the mid-30s or higher — a very different number from the 15% or 20% many sellers assume applies to real estate.

A pre-sale checklist

Before you list, do four things. Project your full-year MAGI including the expected gain, so you know whether and by how much you cross the NIIT threshold. Split the gain into its recapture and capital-gain components using your depreciation schedule. Model the alternatives — a 1031 exchange, an installment sale, or timing the sale into a lower-income year — against simply paying the tax. And set aside the cash for federal tax, the NIIT, and state tax, plus make any needed estimated payment in the quarter of the sale to avoid an underpayment penalty. A short projection with a CPA on any sale with six figures of gain routinely pays for itself.

Frequently asked questions

Does depreciation recapture trigger the NIIT?

Yes — if your MAGI exceeds the threshold, the gain from selling a rental (including the recapture portion) counts as net investment income subject to the 3.8% tax.

What is the NIIT threshold?

$200,000 MAGI for single filers, $250,000 for married filing jointly (and $125,000 for married filing separately). The 3.8% rate applies to the lesser of NII or the MAGI above those thresholds. The thresholds are not indexed for inflation.

Can a 1031 exchange avoid the NIIT?

Yes — because a properly structured 1031 exchange defers recognition of the entire gain, there is no net investment income from the sale in the exchange year, so no NIIT applies until you later sell without exchanging.

Which form reports the NIIT?

Form 8960, Net Investment Income Tax, computes the 3.8% and carries it to your Form 1040. Because it isn't withheld, consider making an estimated payment in the quarter of a large sale to avoid an underpayment penalty.

Does the Section 121 exclusion reduce the NIIT?

Gain excluded under the $250,000/$500,000 primary-residence exclusion is also excluded from net investment income. However, depreciation recapture from a period of rental use is not excludable and can still be subject to the NIIT.

Is the NIIT the same as the Additional Medicare Tax?

No. The 3.8% NIIT applies to investment income like rents and capital gains, while the separate 0.9% Additional Medicare Tax applies to wages and self-employment income above the same thresholds. A dollar is subject to one or the other, never both.

Does a rental in a trust face the NIIT sooner?

Yes. Non-grantor trusts and estates hit the 3.8% NIIT once income exceeds roughly $15,000 — the top trust bracket threshold — far below the $250,000 individual threshold. Distributing net investment income to beneficiaries can reduce the total NIIT.

Can an installment sale reduce the NIIT on a rental sale?

It can help. Spreading the gain across several years under an installment sale keeps each year's modified AGI lower, which can shrink the amount by which you exceed the NIIT threshold in any single year and therefore reduce the total 3.8% tax over the life of the note.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.

Depreciation Recapture and the Net Investment Income Tax