On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act ("ACA"). Although the ACA has not been fully implemented, some of its provisions have already taken effect. One of the more significant parts of the ACA that went into effect beginning in 2013 is a new 3.8% income tax on "net investment income" on certain high income individuals, trusts and estates. The below discussion considers in detail how this new 3.8% tax applies to rental income.
1. Q: I receive rental income from some residential as well as commercial real estate that I own. Is the net rental income from these properties subject to any new federal income taxes beginning in 2013?
A: Possibly. For tax years beginning on or after January 1, 2013, individuals, trusts and estates will have to pay a new federal income tax at a rate of 3.8% on the lesser of (i) their "Net Investment Income" (which is defined to include, among other categories of income, net rental income), or (ii) the excess of their "modified adjusted gross income" over a statutorily prescribed threshold amount which varies with the filing status of the taxpayer.
2. Q: What are the threshold amounts for individuals for purposes of this new tax?
A: Individuals will owe the tax if they have "Net Investment Income" ("NII") and also have "modified adjusted gross income" in excess of the following amounts:
| Filing Status
||Threshold Amount="Modified Adjusted Gross Income" (= "Adjusted Gross Income" For TPs with no income earned in a foreign country)
| Married Filing Jointly
| Married Filing Separately
| Head of Household
| Qualifying widow(er) with dependent child
3. Q: Does this new 3.8% tax on NII mean that I will have to pay this tax on all of my net rental income?
A: Not necessarily.
Under the final regulations promulgated last year by the IRS on the application of the new 3.8% tax (the "NII Regulations"), if (1) you can qualify as a "Real Estate Professional" as that term is defined in Section 469(c)(7) of the Internal Revenue Code (the "Code"), and (2) your rental activities rise to the level of a "trade or business" that is not considered to be a "passive activity" within the meaning of Code Section 469(c), then as to the rental activities for which both tests are met, none of the net rental income is subject to the new 3.8% income tax.
In addition, the NII Regulations also permit "self-rental" income to escape the new 3.8% tax provided the property producing net rental income (and in which the taxpayer has an ownership interest) is rented to an active trade or business in which the taxpayer "materially participates" (as that term is defined in the IRC Section 469 Regulations).
4. Q: What do I have to do to qualify as a "Real Estate Professional"?
A: For any given tax year, you must pass the 2 tests set forth under IRC Section
469(c)(7)(B). These are:
(1) More than 50% of the personal services you perform in all trades or businesses for the tax year must be performed in a real estate activity in which you "materially participate"; and
(2) You must perform more than 750 hours during the tax year in the real estate activity in which you "materially participate".
KEEP IN MIND: In determining the real estate activity being considered for this purpose, the taxpayer can elect to group one or more of his real estate activities together and thus be treated as one real estate activity. In that case, requirements (1) and (2) above are considered with respect to the combined real estate activities.
5. Q: I think I can qualify as a "Real Estate Professional" for all of my real estate rental activities, or at least the ones for which I want to be able to avoid the imposition of the new 3.8% income tax. What must I show in order to demonstrate that these activities rise to the level of a "trade or business" that is not considered to be a "passive activity" within the meaning of IRC Section 469?
A: The showing that a taxpayer must make in demonstrating that his real estate activities rise to the level of a "trade or business" for this purpose does not have much in the way of any bright line tests. As a general rule, the case law in this area indicates that it is necessary for the taxpayer to show that his involvement in the activity(ies) is regular, continuous and substantial.
6. Q: So, how does a taxpayer show that his involvement in his each of his real estate activities for which he seeks to avoid the new 3.8% income tax is regular, continuous, and substantial?
A: The following simplified examples probably best demonstrate how a taxpayer satisfies these standards:
Example 1: If the taxpayer owns and manages several rental properties, each with multiple tenants, then each property is quite likely to be considered a "trade or business" for this purpose due to the regular, continuous, and substantial efforts required of the taxpayer to operate each of his rental properties.
Example 2: If, however, the taxpayer only rents out single family homes, and the only management efforts by the taxpayer with respect to the properties is to collect the monthly rent check, or in a commercial setting, if the taxpayer's rental leases are triple-net leases, then, conversely, the taxpayer's rental activity(ies) as to each such property are much less likely to rise to the level of a "trade or business".
7. Q: It seems that determining "trade or business" status for each of the taxpayer's real estate rental properties could by daunting for taxpayers with multiple properties. Are there any safe harbors that a taxpayer can claim to take the position that it has met the above mentioned "trade or business" standard for all of the taxpayer's real estate rental properties?
A: Yes. For a taxpayer who is considered a "Real Estate Professional" (see Q&A 4, above) as to one or more rental real estate activities (under the same grouping rules that apply for purposes of determining if the taxpayer is a "Real Estate Professional", except as noted below), the rental income from that singular or grouped rental activity during any given tax year is deemed to be derived in the ordinary course of a "trade or business", and thus will not be treated as NII, if the following condition is met. The taxpayer participates in the singular or grouped real estate activity(ies) for more than 500 hours during such tax year. As alluded to above, for purposes of this safe harbor, the grouping rules that apply are somewhat more stringent than those that apply for determining if the taxpayer is, in the first place, a Real Estate Professional. In this case, and solely for purposes of this safe harbor, the taxpayer can group those real estate activities only to the extent the activities solely pertain to "rental" real estate activities rather than with respect to any other form of real estate activities (as can be done when determining if a taxpayer is a Real Estate Professional).
For additional information regarding this topic, please contact your local UHY LLP professional.