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November 12, 2013

How does the 3.8% Net Investment Income Tax Apply to Real Estate Professionals?

As you’ve probably noticed, a CPA’s answer to almost every question is, “It depends”.  So, when you ask your accountant how you’ll be impacted by the new 3.8% net investment income tax, you already know the answer, right?  But what does it depend upon?  There are actually quite a few variables.

Generally speaking, if your 2013 adjusted gross income (AGI) exceeds $250,000 ($200,000 for single filers) you will incur an additional 3.8% tax on your net investment income (NII).  NII includes portfolio income (interest, dividends, and capital gains), annuity income, income from passive investments, and rental income.

There are, however, some possible exceptions to the new law.  The following items are not subject to the new 3.8% Surtax:

  1. S corporation distributions to owners who materially participate
  2. Rents received by ‘real estate professionals’ who materially participate in the underlying activity
  3. Grouping of rental activities with businesses in which owners materially participate
  4. Recharacterized rents received from businesses in which the owner materially participates
  5. Non-portfolio capital gains or losses attributable to property held by an entity in which the owner materially participates.

Some aspects of these exceptions require additional explanation and, to some degree, are subject to interpretation because the proposed regulations outlining the new 3.8% tax are not yet final.

One somewhat controversial aspect of the 3.8% Surtax is how it will apply to self-rented property.  It’s a common tax planning strategy for business owners who own their own building to hold it separately from their operating entity and to pay themselves rent.  The IRS requires income from self-rented property to be categorized as non-passive income regardless of the material participation rules.  The question is whether or not this ‘non-passive’ income is subject to the 3.8% Surtax.  The answer is, of course, it depends…

While tax law isn’t always clear, it is clear that your Anders advisors are adept at interpreting tax law and we’re always available to discuss how to minimize your tax liability; please contact us to discuss these concepts in more detail.

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