Does a 1031 Exchange Avoid the 3.8% NIIT?

Generally, yes, for the part of the gain you defer. The 3.8% net investment income tax, often shortened to NIIT, applies to gain that is recognised in a given year. A properly completed 1031 exchange means the deferred gain is not recognised in the year of sale, so it does not count toward the tax that year. Any boot you take, whether cash or debt relief, is recognised gain, and it can be subject to the NIIT if your income is above the threshold.

What is the net investment income tax?

The net investment income tax is a 3.8% federal tax that sits on top of ordinary income tax and capital gains tax. It came into effect in 2013 under Section 1411 of the Internal Revenue Code. It applies to individuals, estates and trusts whose income is above a set threshold.

For individuals, the thresholds are based on modified adjusted gross income:

• ›$250,000 for married couples filing jointly
• ›$200,000 for single filers and heads of household
• ›$125,000 for married individuals filing separately

These thresholds are written into the statute and are not adjusted for inflation, which means more owners cross them every year. Trusts and estates face a much lower threshold, the income level where the top trust tax bracket begins, so property held in a non grantor trust can be exposed at modest income levels.

Is gain from selling a rental property net investment income?

In most cases it is. Net investment income includes rents and gains from the sale of property held for investment. A typical landlord who owns a rental and sells it at a gain will have that gain counted as net investment income.

There are exceptions. Gain from property used in a trade or business that is not a passive activity for you is generally excluded. In practice this is where real estate professional status comes in. An owner who qualifies as a real estate professional and materially participates in a rental activity that rises to the level of a trade or business may be able to treat that income and gain as outside the NIIT. The rules are technical and fact specific, so this is a conversation to have with your CPA rather than an assumption to make.

How is the NIIT calculated?

The tax is 3.8% of the lesser of two figures:

• ›Your net investment income for the year
• ›The amount by which your modified adjusted gross income exceeds your threshold

That second figure is what makes the timing and size of recognised gain so important. A large gain in one year can push income well above the threshold. A smaller recognised amount may stay below it.

How does a 1031 exchange affect the NIIT?

A 1031 exchange does not make gain disappear. It defers recognition. The gain you do not recognise this year is carried into the basis of your replacement property and stays deferred until a later taxable sale.

Because the NIIT applies only to gain recognised in the year, the deferred portion is not part of your net investment income for the year of the exchange. It also does not inflate your modified adjusted gross income, which matters for the threshold test.

The deferral works in the same way it does for capital gains tax. If you later sell the replacement property in a taxable sale, the deferred gain is recognised at that point, and the NIIT rules in force then will apply. If you hold until death, heirs generally receive a stepped up basis under current law, and the deferred gain is not taxed to them.

What happens to the NIIT when you take boot?

Boot is anything you receive in the exchange that is not like kind real property. Cash left over after you buy the replacement property is boot. So is a reduction in debt that you do not offset with new debt or added cash.

Boot is recognised gain, up to the amount of your total gain. It goes into your income for the year of the exchange and, for most rental owners, it counts as net investment income. Whether it triggers the NIIT depends on where it leaves your modified adjusted gross income relative to the threshold.

A worked example of the NIIT with and without an exchange

The figures below are illustrative only. They are simplified to show how the calculation works, not to estimate anyone's tax.

Assume a married couple filing jointly. Their other income is wages of $180,000, so before the sale they are below the $250,000 threshold. They sell a rental with a gain of $400,000. For simplicity, assume they have no other investment income.

• ›Taxable sale with no exchange: income rises to $580,000. That is $330,000 over the threshold. Net investment income is $400,000. The lesser figure is $330,000, and 3.8% of that is $12,540 of NIIT, on top of capital gains tax and depreciation recapture.
• ›Full 1031 exchange with no boot: no gain is recognised this year. Income stays at $180,000 and no NIIT applies to the sale.
• ›Exchange with $60,000 of boot: income rises to $240,000, which is still under the threshold. No NIIT applies, although the $60,000 is still subject to capital gains tax and possibly recapture.
• ›Exchange with $100,000 of boot: income rises to $280,000, which is $30,000 over the threshold. The lesser figure is $30,000, and 3.8% of that is $1,140 of NIIT.

The point is not the specific numbers. It is that the NIIT has a threshold, and the amount of boot you take can decide whether you cross it. Your CPA can model your actual figures, including other investment income, state tax and recapture.

Does depreciation recapture count toward the NIIT?

Yes, if it is recognised. Depreciation recapture on a rental is part of the gain on sale, and for most owners it is net investment income. In a fully deferred exchange, recapture is deferred along with the rest of the gain. If you take boot, your CPA will work out how much of the recognised gain relates to past depreciation, which can be taxed at a different rate from the rest, and that is one more reason to review boot carefully before you close.

Questions to ask your CPA before you close

• ›Is my gain on this sale net investment income, or could real estate professional status change that?
• ›What is my expected modified adjusted gross income for the year without the sale?
• ›How much boot, if any, would keep me under the NIIT threshold?
• ›If I own through a trust, what threshold applies to it?

The bottom line

The 3.8% net investment income tax is one more layer that a completed 1031 exchange can defer along with capital gains tax. It is not avoided forever, only postponed, and boot brings it back into play in the year of sale. Knowing your threshold before closing gives you and your CPA a clearer picture of what keeping some cash would actually cost. Your Qualified Intermediary can confirm the mechanics of the exchange, and your CPA can confirm the tax.