Real Estate Changes for 2013

Earlier this year, Congress passed The American Taxpayer Relief Act of 2012 (ATRA), which enacted significant tax law changes and tax rate increases for 2013 and beyond.  ATRA was significant, but nothing new or unexpected; it primarily addressed the expiration of several tax provisions that were widely referred to as the ‘Bush Era Tax Cuts’.  There was, however, another set of tax law changes that became effective January 2013 that have the attention of the real estate community – The Affordable Care Act.  The Affordable Care Act has garnered much more publicity for its implications on our nation’s healthcare system than for its tax ramifications, but the tax changes will have a huge impact for real estate professionals and even novice investors.

The biggest tax changes for those involved in real estate are related to the additional 3.8% “Medicare surcharge”.  Historically, Medicare taxes have only been imposed on “earned” income, mainly wages and self-employment income. However, beginning in 2013, the 3.8% Medicare tax will be imposed on all income, including unearned rental income. The new tax, however, applies only to individuals with relatively high levels of income.

The 3.8% additional tax applies to taxpayers who have “Net Investment Income” exceeding a threshold of $200,000 for individuals and $250,000 for married couples.  Net Investment Income is defined as passive income from interest, royalties, dividends, annuities, capital gains, and rents.  Therefore, your rental income is subject to the tax unless you qualify as a real estate professional under IRC Section 1141. If you qualify as a real estate professional, your real estate income is categorized as active and not passive, therefore avoiding the 3.8% Medicare tax. But, you’re not entirely out of the woods. Earned income from wages, self-employment, and active participation in other activities such as real estate, is subject to a .9% Medicare tax. This 2.9% difference in tax between active and passive participation is crucial to understand. IRC Section 469 dives into the rules and requirements to meet active participation. In a previous blog post, we summarized the passive vs. active participation rules, which you can view here. It is important to discuss your level of participation with your tax advisor to ensure you are classified properly.

Now is the time to start planning for the 2013 tax changes. The tax increases should be factored into your quarterly payments or increased withholding so that you are not hit with a tax surprise next April.