The Health Care and Education Reconciliation Act of 2010 contains a provision that will subject certain individuals to a 3.8% Medicare tax beginning on January 1, 2013. This tax will be on net investment income such as interest, dividends, annuities, royalties and net rental income. The tax has been labeled by some as a “home sales tax” or “real estate tax” and is not well understood.
The 3.8% surtax is imposed on the lesser of an individual’s:
1) “net investment income” (NII), or
2) the excess of “modified adjusted gross income” over $250,000 (for married filing jointly)
Net investment income is generally defined as net income from interest, dividends, annuities, royalties, net rental income, net capital gains from investments, and income from passive investments.
The statute specifically states that net investment income includes rent other than such income which is derived in the ordinary course of a non-passive trade or business. It would appear that the test would be whether you are considered active or passive for income tax purposes.
Normally, rental real estate losses are considered passive activities and are subject to passive activity loss limitations which limit losses from passive activities to passive income recognized. However, a taxpayer who qualifies as a real estate professional and materially participates in their real estate rentals may avoid passive loss limitations and deduct rental real estate losses against other income sources (commissions, wages, etc.) under IRC Section 469©(7).
So, it may be possible for a real estate professional to avoid the 3.8% Medicare tax as income would be considered derived in the ordinary course of a non-passive trade or business.
What are the requirements for qualification as a real estate professional?
• Taxpayer owns rental real estate
• More than 50% of the taxpayer’s personal services during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates, and
• The taxpayer must perform more than 750 hours of service in the same trades or businesses. Additionally, the taxpayer must devote more than one-half of personal services working hours to his real estate business. Hours spent as an employee are not counted unless the employee is also a greater than 5% owner of the real estate company.
Activities in the real property trades or businesses include the following:
1. Real estate developers, builders, and contractors,
2. Owners of rental properties,
3. Property managers, and
4. Participants in the Real Estate Brokerage business – provided they meet the 50% participation and 750 hour requirement tests.
Note: Real Estate Appraisers and Loan Brokers are excluded. Material Participation in real estate rentals includes:
1. Managing and operating the rental real estate activity for more than 500 hours per year; or
2. Doing substantially all the work required to manage and operate the rental real estate during the year, or
3. Working more than 100 hours during the year with no one participating more than the taxpayer
4. Note: Activity of one spouse can be attributed to the other spouse and activity from multiple properties can be combined through use of the proper elections (See aggregation rules below).
If the taxpayer qualifies as a real estate professional and materially participates in the real estate rental activities, the taxpayer is allowed to deduct rental real estate losses.
AGGREGATION OF RENTAL REAL ESTATE
Each rental is a separate activity, unless all rentals are combined. A taxpayer may elect to combine all interests in real estate, including real estate held through passthrough entities, as one activity. This allows the taxpayer to meet the material participation tests when examined cumulatively. The election to treat all interests in rental real estate as a single activity is binding for all future years unless there is a material change in facts and circumstances. Taxpayers who fail to formally elect to aggregate properties may make a late election, attaching a statement to their return indicating that the taxpayer wishes to aggregate the properties. This can only be done if the affected tax returns were filed as if the election had been made.
As with most tax law issues, the rules can be somewhat complicated. Please don’t hesitate to contact your Elliott Davis Real Estate Practice advisor for further information.