Net Investment Income Tax: The 3.8% Medicare Surtax on Passive Income
How the 3.8% net investment income tax works, MAGI thresholds, what counts as NII, real estate professional exception, and strategies to reduce exposure.
The 3.8% Tax Most High Earners Forget to Plan For
The Net Investment Income Tax (NIIT), enacted as part of the Affordable Care Act in 2013 and codified at Section 1411, imposes a 3.8% surtax on the lesser of a taxpayer's net investment income or the amount by which modified adjusted gross income (MAGI) exceeds a statutory threshold. Unlike many tax provisions, the NIIT thresholds are not inflation-adjusted — the $200,000 single / $250,000 married thresholds were set in 2013 and have remained unchanged, meaning more taxpayers are captured each year as incomes rise. The IRS collected approximately $60 billion in NIIT revenue in 2021.
The NIIT Thresholds and How the Tax Is Calculated
The 3.8% applies to the lesser of two amounts: net investment income, or the excess of MAGI over the applicable threshold. This means taxpayers with moderate NII can owe NIIT even if most of their income is from wages.
| Filing Status | MAGI Threshold | NIIT Rate | Maximum NII Considered |
|---|---|---|---|
| Single | $200,000 | 3.8% | Lesser of NII or (MAGI - $200,000) |
| Married Filing Jointly | $250,000 | 3.8% | Lesser of NII or (MAGI - $250,000) |
| Married Filing Separately | $125,000 | 3.8% | Lesser of NII or (MAGI - $125,000) |
| Estates and Trusts | $15,200 (2024) | 3.8% | Lesser of undistributed NII or (AGI - $15,200) |
Example: A married couple has $200,000 in wages and $80,000 in investment income. MAGI is $280,000 — $30,000 above the $250,000 threshold. NII is $80,000. The NIIT applies to the lesser of $30,000 or $80,000, so the tax is $30,000 × 3.8% = $1,140.
What Counts as Net Investment Income
Net investment income is broadly defined to capture most passive earnings from financial and real property assets.
- Interest income (bank accounts, bonds, money market funds)
- Ordinary dividends and qualified dividends
- Capital gains from the sale of stocks, bonds, mutual funds, and other securities
- Capital gains from the sale of investment real estate not used in a trade or business
- Rental income from passive rental activities
- Passive income from partnerships, S-corporations, and trusts
- Annuity income
- Royalties from intellectual property held as investments
What Is Excluded from NII
| Income Type | Excluded? | Reason |
|---|---|---|
| Wages and self-employment income | Yes | Active trade or business income; already subject to Medicare tax |
| Social Security benefits | Yes | Not investment income |
| Qualified retirement distributions (IRA, 401k) | Yes | Tax-deferred accounts; ordinary income upon withdrawal |
| Tax-exempt municipal bond interest | Yes | Excluded from NII and from MAGI calculation |
| Active S-corp or partnership income | Yes | Material participation in a trade or business |
| Gains on primary residence (within exclusion) | Yes | Section 121 exclusion applies before NIIT |
The Real Estate Professional Exception
Rental income is typically passive and thus subject to NIIT. However, a taxpayer who qualifies as a real estate professional under Section 469(c)(7) — spending more than 750 hours per year and more than 50% of total working hours on real property trades or businesses — can treat rental activities as non-passive. Non-passive rental income from material participation is excluded from NII. This exception is why some high-income real estate investors restructure their activities to meet the real estate professional test.
- Both spouses in a married filing joint return must each meet the test independently — one spouse's qualification does not automatically cover the other's rental income
- Time logs and calendars are required to document the 750-hour threshold
- Material participation in individual rental properties is tested separately unless a grouping election is made under Treasury Regulation 1.469-9(g)
Strategies to Reduce NIIT Exposure
- Maximize pre-tax retirement contributions: 401(k), SEP-IRA, and defined benefit contributions reduce MAGI directly, potentially bringing it below the threshold
- Municipal bonds: Interest from tax-exempt bonds is excluded from both MAGI and NII, providing a double benefit for high earners near the threshold
- Real estate professional qualification: Converting passive rental income to non-passive income eliminates NIIT on that income
- Installment sales: Spreading capital gain recognition over multiple years can keep MAGI below the threshold in each year
- Harvesting losses: Capital losses offset capital gains dollar-for-dollar, reducing both NII and MAGI
This article is for informational purposes only and does not constitute financial or tax advice.
Related Articles
taxation
Tax-Loss Harvesting Strategies to Offset Capital Gains
Learn how tax-loss harvesting works, when to use it, wash-sale rules to avoid, and how to strategically offset short- and long-term capital gains.
9 min read
taxation
Estate Tax: How Inheritance Gets Taxed and Who Pays
Understand how estate taxes work in the United States, including federal exemption thresholds, state-level variations, inheritance tax distinctions, and common planning strategies.
9 min read
taxation
LLC vs S-Corp Tax Differences: Which Structure Saves More?
A detailed comparison of LLC and S-Corp tax treatment for self-employed owners, covering self-employment tax, pass-through income, and when each structure wins.
9 min read
taxation
Self-Employed Tax Deductions: Every Write-Off You Can Legally Claim
A complete guide to self-employment tax deductions including home office, health insurance, retirement contributions, vehicle expenses, and the SE tax deduction.
9 min read