The 3.8 percent Medicare surtax on net investment income takes effect for the 2013 tax year. The tax is included in Section 1402 of the Health Care and Reconciliation Act of 2010.
The tax applies to various sources of passive income including interest, dividends, capital gains, royalties and net rental income for single taxpayers with an adjusted gross income (AGI) of $200,000 or $250,000 for taxpayers with married, filing jointly status. The tax is calculated as the lesser of the taxpayer’s net investment income or the taxpayer’s excess AGI over the threshold amount multiplied by 3.8 percent.
A rental real estate activity is automatically deemed passive under the Tax Reform Act of 1986. An exception was created in 1994 for real estate professionals. Up to now, real estate professionals with taxable income producing rental real estate activities had little to no incentive to consider that exception. The new tax changes that.
A taxpayer with rental income may be able to avoid the net investment income tax by demonstrating he or she is a qualifying real estate professional. This requires performing more than 750 hours of personal services in real property trades or businesses in which the taxpayer materially participates. More than half of total personal service hours for the year must also be in the real property trades or businesses in which the taxpayer materially participates.
A real property trade or business is broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. To qualify as materially participating, a taxpayer must satisfy one of the following seven tests:
1) The taxpayer’s participation in the activity for the year must exceed 500 hours.
2) The taxpayer’s participation constitutes substantially all participation by all individuals in the activity for the year.
3) The taxpayer’s yearly participation exceeds 100 hours and no other individual participates more than the taxpayer.
4) The activity is a significant participation activity in which the taxpayer participates for more than 100 hours during the year, with the taxpayer’s annual participation in all significant activities exceeding 500 hours. A significant participation activity is generally a trade or business activity (other than a rental activity) that the taxpayer participates in for more than 100 hours during the year, but does not materially participate under the other material participation tests.
5) The taxpayer materially participated in the activity for any five tax years during the 10 immediately preceding tax years.
6) For a personal service activity, the taxpayer materially participated for any three tax years prior to the current tax year. Personal service fields include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital is not a material income-producing factor.
7) Based on all facts and circumstances, the taxpayer participates on a regular, continuous and substantial basis during the year. This generally requires more than 100 hours of participation, with no one else receiving compensation for management of the activity. No other individual can spend more time managing the activity, either.
Limited partners are generally not considered to materially participate in a limited partnership’s activities. To be considered a material participant, a limited partner must pass either the first, fifth or sixth tests listed above. A limited liability company (LLC) member may be able to all apply all seven tests if the member had rights to participate in management of the entity at any time during the year.
The material participation burden can be eased by electing to treat all interests in rental real estate activities as a single activity. This election can be made any year the taxpayer qualifies as a real estate professional; however, such an election is irrevocable unless there is a material change in the taxpayer’s fact and circumstances.
The new net investment income tax makes it essential that a real estate professional evaluate material participation in general and the full ramifications of grouping rental real estate activities into a single activity. Typical considerations are:
- Whether rental real estate activities are producing taxable income or loss.
- The extent to which a taxpayer has passive income from non-real estate activities.
- Suspended losses from activities for which the grouping is contemplated.
- The time horizon of a possible disposition of an activity.
Real estate professionals are required to substantiate their participation in activities by any reasonable method, including maintaining traditional log books or calendars that list activity hours. These records should be kept contemporaneously with the participation.
All relevant facts and the merits of material participation in 2013 should be evaluated with a tax advisor.
— Chase W. Lewis, CPA, is a senior manager in tax and strategic business services at Weaver. He can be reached at 972.448.9211 or Chase.Lewis@WeaverLLP.com.