What Is the Net Investment Income Tax (NIIT)? A Chicago Tax Planner’s Guide to the 3.8% Surtax (2026)

Quick answer: The Net Investment Income Tax (NIIT) is a 3.8% federal tax under IRC §1411 on investment income — interest, dividends, capital gains, rents, royalties, and passive business income — for taxpayers whose modified adjusted gross income (MAGI) exceeds $200,000 (single) or $250,000 (married filing jointly). You pay 3.8% on the lesser of your net investment income or the amount your MAGI exceeds the threshold. It is reported on Form 8960 and flows to your Form 1040.

Key facts at a glance

Who pays the Net Investment Income Tax?

You owe the NIIT only if both conditions are met in the same year:

1. You have net investment income (NII), and
2. Your MAGI exceeds the threshold for your filing status.

Crossing the threshold does not tax all of your investment income. The tax applies to the smaller of your NII or your MAGI excess over the threshold.

Estates and trusts are also subject to the NIIT, on the lesser of undistributed net investment income or AGI above the dollar amount where the top trust bracket begins — a far lower threshold than individuals face. Trustees should treat that as a separate planning conversation.

How is the 3.8% NIIT calculated?

NIIT = 3.8% × the lesser of (a) net investment income or (b) MAGI minus your filing-status threshold.

For most taxpayers, MAGI equals adjusted gross income (AGI). It only differs if you claim the foreign earned income exclusion or hold interests in certain foreign corporations.

Worked example

A single Chicago professional has MAGI of $220,000, including $50,000 of net investment income.

• Threshold: $200,000
• MAGI excess: $20,000
• NII: $50,000
• Lesser figure: $20,000
• NIIT owed: 3.8% × $20,000 = $760

The taxpayer had $50,000 of investment income but paid the surtax on only $20,000, because MAGI cleared the line by only $20,000. Reducing either number reduces the tax.

What counts as net investment income?

Included in NII:

• Interest and dividends
• Capital gains on stocks, bonds, mutual funds, and investment real estate
• Rental and royalty income
• Non-qualified annuity income
• Income from passive business activities (under §469)
• Income from trading financial instruments or commodities

Not included in NII:

• Wages and salaries
• Self-employment income
• Active (non-passive) trade or business income
• Social Security benefits and unemployment compensation
• Tax-exempt municipal bond interest
• Distributions from 401(k)s, 403(b)s, IRAs, and other qualified plans

Allocable deductions — investment interest expense, advisory fees where deductible, rental expenses — reduce NII.

Is the NIIT the same as the Additional Medicare Tax?

No. The 0.9% Additional Medicare Tax applies to wages and self-employment income above similar thresholds. The 3.8% NIIT applies to investment income. A high earner with a large salary and a strong portfolio can owe both in the same year, but on different dollars.

Why do more Chicago households owe the NIIT every year?

Because the thresholds have been frozen since 2013. A $250,000 joint threshold in 2013 dollars buys considerably less in 2026, and ordinary raises, portfolio growth, and rising rents on Lincoln Park or Lakeview investment properties push more families over the line each year without any change in behavior.

One-time events are the most common trigger for first-time NIIT payers:

• Selling a business or a rental property
• A large Roth conversion
• Vesting or selling employer stock (RSUs, ISOs, ESPP shares)
• A liquidity event on startup equity

For Illinois residents there is a second layer: Illinois does not have a separate investment income surtax, but its flat income tax applies to the same gains and dividends. Federal capital gains rates, the 3.8% NIIT, and Illinois tax combine to set your true marginal rate on a sale — and that combined number is what should drive the timing decision.

How can you reduce or avoid the Net Investment Income Tax?

Because the tax is the lesser of two figures, planning works on both levers. None of these strategies eliminates the tax by itself; each reduces or defers exposure and carries qualification rules and economic tradeoffs.

Strategies that lower your MAGI

1. Forecast before year-end. Project MAGI and NII by early Q4 so you know whether you will cross the threshold and by how much.
2. Maximize pre-tax retirement deferrals. Traditional 401(k) contributions reduce taxable wages and therefore MAGI.
3. Fund a Health Savings Account. HSA contributions are deductible in arriving at AGI whether or not you itemize.
4. Shift taxable bonds toward municipals. Muni interest is excluded from both MAGI and NII. Compare after-tax yields before reallocating.
5. Spread Roth conversions across years. Conversion income is not NII, but it raises MAGI and can drag other investment income into the surtax. Convert in lower-income years or in tranches.
6. Use qualified charitable distributions after 70½. A QCD sends IRA dollars directly to charity without touching AGI.
7. Update withholding and estimates. The NIIT is subject to estimated-tax rules; a surprise surtax can also mean an underpayment penalty.

Strategies that lower your net investment income

1. Harvest capital losses. Only net gains enter NII, so realized losses reduce the base directly.
2. Time discretionary sales. Splitting a large gain across two tax years, or using installment reporting where available, can keep each year closer to the threshold.
3. Use a §1031 exchange on investment real estate. Deferred gain stays out of NII until the replacement property is ultimately sold.
4. Preserve the §121 home-sale exclusion. Up to $250,000 (single) or $500,000 (joint) of gain on a primary residence is excluded from both regular tax and NII if you meet the two-of-five-year ownership and use tests.
5. Document material participation. Ordinary income from an operating business you materially participate in is generally outside the NIIT. Rental activities are treated more restrictively — material participation alone does not make rental income nonpassive — so review your §469 status and keep contemporaneous records.

Common NIIT misconceptions

“Once I cross the threshold, all my investment income is taxed at 3.8%.” No. Only the lesser of NII or your MAGI excess is taxed.

“My IRA withdrawals are subject to the NIIT.” The distributions are not NII, but they raise MAGI and can expose other investment income.

“Selling my house triggers the 3.8% tax.” Gain excluded under §121 is also excluded from NII. Only gain above the exclusion is exposed.

“The thresholds rise with inflation.” They do not. They have been $200,000 / $250,000 / $125,000 since 2013.

Year-end NIIT checklist

• Project full-year MAGI and net investment income before December.
• Calculate how far MAGI sits above or below your threshold.
• Review realized and unrealized gains and losses for harvesting.
• Decide whether any large discretionary sale should be deferred or split.
• Confirm 401(k), HSA, and (if eligible) QCD opportunities are used.
• Model the MAGI impact of any planned Roth conversion.
• Verify withholding and estimated payments cover the surtax.
• Document material participation in operating businesses and separately confirm any rental exception.

Frequently asked questions

What is the NIIT threshold for 2026?
$200,000 for single and head-of-household filers, $250,000 for married filing jointly, and $125,000 for married filing separately. These amounts are not adjusted for inflation.

Does the NIIT apply to rental income?
Generally yes. Rental income is net investment income unless a narrow exception applies, such as qualifying as a real estate professional with the rental treated as a nonpassive trade or business.

Does the NIIT apply to the sale of a business?
It depends. Gain on an interest in a business you materially participate in can fall outside the NIIT; gain on a passive interest is generally included. The structure of the sale matters.

Are 401(k) and IRA distributions subject to the NIIT?
No. Qualified plan distributions are excluded from net investment income, though they do increase MAGI.

Does Illinois have a net investment income tax?
No. Illinois has no separate surtax on investment income, but its flat income tax applies to the same gains, dividends, and rents.

How do I report the NIIT?
On IRS Form 8960, which carries the tax to your Form 1040.

Can a nonresident alien owe the NIIT?
Generally no. Nonresident aliens are outside the tax, though dual-status and treaty situations require review.

The bottom line

The NIIT is a 3.8% tax on the smaller of two numbers — your net investment income and your MAGI above a frozen threshold. That two-lever structure is exactly what makes it plannable. Business owners, high-income W-2 earners, and investors in Chicago who forecast before year-end can often reduce or defer the tax through timing, account selection, and entity and participation decisions.

Pasquesi Partners LLC works with Chicago entrepreneurs, executives, and investors on proactive tax strategy, not just compliance. If a sale, conversion, or strong investment year is on your horizon, we’re happy to run the numbers with you before December 31.