How to Double-Check State Income Tax for NIIT

You can claim a state income tax deduction for NIIT purposes, but only for the share of state and local income taxes tied to your investment income. That deduction goes on Form 8960, Line 9b, and the IRS lets you use any reasonable method to figure the allocation.¹ The most common approach is a simple ratio: investment income divided by total AGI, applied to your total state tax bill. Skip the deduction and you overpay the 3.8% surtax; overstate it and you invite an audit adjustment.

Which State and Local Taxes Qualify on Line 9b

The final Treasury regulations kept the position from the proposed rules: taxes described in Section 164(a)(3) are deductible against net investment income when properly allocated.² In practice, that covers three categories of taxes to the extent they relate to investment income:

State, local, and foreign income taxes
State and local real property taxes
State and local personal property taxes

Sales taxes never qualify for Line 9b, even in states where you take a sales tax deduction on Schedule A instead of income tax. And if you claimed a foreign tax credit for any portion of foreign income taxes paid, you cannot also deduct those foreign taxes on Line 9b.¹ You pick one benefit or the other for the same tax dollars.

One more constraint sits underneath all of this. A deduction has to be allowable in computing your regular taxable income before it can reduce NII. If the deduction is disallowed on your 1040, it cannot rescue you on Form 8960.¹

How to Allocate Your State Tax to Investment Income

You cannot deduct every dollar of state income tax you paid. Only the portion attributable to investment income counts. The regulations accept any reasonable method, and the workhorse method is a proportional ratio.³

The steps:

Add up your gross investment income for the year (interest, dividends, capital gains, rents, royalties, and other categories that flow into Part I of Form 8960).
Divide that figure by your total adjusted gross income to get an allocation percentage.
Multiply that percentage by your total state and local income tax liability for the year.
Enter the result on Line 9b.

A worked example. You earned $300,000 in total AGI, of which $100,000 came from investment sources. You paid $15,000 in state income tax. Your allocation ratio is $100,000 ÷ $300,000, or 33.3%. Applied to the $15,000 state tax bill, roughly $5,000 is allocable to investment income and belongs on Line 9b. That deduction reduces your net investment income before the 3.8% rate applies, cutting your NIIT by about $190.

The ratio method works cleanly when your income streams are stable and your state tax is a flat percentage. If your state uses graduated rates or taxes some categories differently (for example, a lower rate on long-term capital gains, or a full exemption for certain interest), a strict ratio may overstate or understate the true allocation. In those cases a more granular method — tracing the actual state tax on each income category — is also reasonable and often more defensible.

How the SALT Cap Shrinks the Deduction

The $10,000 cap on state and local tax deductions under Section 164(b)(6) reaches into Form 8960. The instructions warn that state and local taxes on Line 9b “may be limited under section 164(b)(6) if the expense is not associated with a trade or business or with a section 212 activity for the production of income.”¹

What that means in practice: if the state taxes you are allocating relate to pure portfolio income like dividends, interest, and capital gains from a brokerage account, the SALT cap can restrict how much you deduct on Line 9b. If instead the taxes are tied to a rental business or another income-producing activity that qualifies under Section 212, that portion may fall outside the cap. The Form 8960 instructions send you to the Schedule A instructions for the limitation details.

The upshot for most high-income investors: if your total state and local tax bill runs well above $10,000 and your investment income is portfolio in nature, the amount you can actually place on Line 9b may be smaller than the raw ratio calculation suggests. Run the allocation first, then apply the cap to test what survives.

Entering the Deduction on Form 8960

Form 8960 attaches to your Form 1040. Part I lists each category of investment income; Part II holds the deductions, including Line 9a for investment interest expense and Line 9b for the allocable state, local, and foreign taxes; Part III computes the tax.⁴

To fill in Line 9b, start with your completed state return. Identify total state income and the portion sourced to investment activity. Compute your allocation percentage, apply it to your state tax liability, test the result against the SALT cap where relevant, and enter the surviving figure.

Keep the workpapers. If the IRS questions Line 9b, you need to show the math. Useful documentation includes your state return showing income and tax paid, the breakdown of investment income by category, the allocation ratio or tracing method you used, and the arithmetic linking those numbers to the amount on Line 9b.

Common Mistakes That Lead to Adjustments

A handful of errors show up repeatedly on Line 9b:

Deducting the full state income tax bill rather than the allocable portion. Only investment-related tax qualifies.
Including sales tax in the Line 9b figure. Sales tax is not eligible, even in no-income-tax states.
Double-counting foreign income taxes already used for a foreign tax credit. You pick the credit or the deduction, not both.
Ignoring the SALT cap when investment income is purely portfolio in nature.
Claiming deductions that are disallowed on the 1040 itself. Investment advisory fees, custodial fees, and similar miscellaneous itemized deductions cannot offset NII because they cannot be taken for regular tax purposes; the suspension of those deductions was made permanent for tax years after 2017.¹

Line 9b rewards a careful hand. The 3.8% rate looks small until you apply it to a five- or six-figure investment income base, at which point every properly allocated deduction has real dollars behind it. Run the ratio, test it against the cap, keep the workpapers, and the deduction holds up.

1
Internal Revenue Service. Instructions for Form 8960 (2025)
2
Internal Revenue Service. Internal Revenue Bulletin 2013-51
3
eCFR. 26 CFR 1.1411-4 – Definition of Net Investment Income
4
Internal Revenue Service. Form 8960 – Net Investment Income Tax