Beginning January 1, 2013, the real estate industry will be faced with an additional 3.8% Medicare tax (the “Surtax”) that will add layers of complexity and more administrative burdens brought about by the Patient Protection and Affordable Care Act (Obamacare). The Surtax applies to the lesser of:
- The taxpayer’s “net investment income”, or
- The taxpayer’s “modified adjusted gross income” less the “applicable threshold”, which is:
- $250,000 for married taxpayers filing jointly.
- $125,000 for married taxpayers filing separately.
- $200,000 for all other taxpayers.
Therefore, the Surtax (and this article) is only applicable to taxpayer’s that have modified adjusted gross income above the threshold amounts. In addition, all provisions of the Code that apply in determining Taxable Income also apply for purposes of the Surtax. For example, any gain that is deferred in a like-kind transfer of real estate under §1031 is also deferred under the Surtax.
In general, the Surtax targets all sources of passive income. For the Surtax, passive income includes 1) interest, dividends, annuities, royalties, rents, 2) income derived in the ordinary course of a trade or business that is considered passive to the individual owner, and 3) gains attributable to the disposition of property that is considered passive to the individual owner.
A rental real estate activity is a passive activity regardless of whether, and to what extent, a taxpayer participates. Furthermore, real estate held by limited partners is presumptively passive. Conversely, owners of LLC and LLP interests in real estate can materially participate in these entities because state law does not restrict their level of participation. “Material participation” is beyond the scope of this article and is discussed here on our website, but it generally requires involvement of more than 500 hours per year by the taxpayer or satisfying one seven enumerated tests in the Regulations.
A qualifying “real estate professional” can overcome this presumption that a rental real estate activity is passive if:
- The taxpayer performs more than half of his or her personal services in real estate trades or businesses, and
- Such efforts exceed 750 hours annually for each real estate activity. (You may elect to group all of the rental real estate activities together, thus requiring 750 hours on a combined basis. We discuss this so-called Grouping Election in more depth here on our website).
Before 2013, the decision to report rental real estate activity as a qualifying real estate professional depended mainly on whether the taxpayer had rental income or loss overall. Qualifying real estate professionals could deduct losses without restriction against other sources of non-passive income, rather than having to suspend such losses. Alternatively, taxpayers with passive rental income likely weren’t compelled to report their rental real estate income as a real estate professional (even if they qualified) because such passive income could be used to offset other non-rental passive losses.
Starting in 2013, it is critical that taxpayers in the real estate industry revisit their tax reporting in order to implement strategies to reduce the burden of the 3.8% Surtax. Net rental income can be excluded from the Surtax if the taxpayer:
- Meets the requirements above to be a qualifying real estate professional,
- Materially participates in the rental activity or activities, and
- His or her involvement in each rental activity rises to the level of a “trade or business” which requires regular, continuous, and substantial participation. (This is a new provision for 2013 that will require real estate owners to take a fresh look at any planning done in previous years to determine how the new Surtax applies to their situation. Being a real estate professional does not automatically satisfy the trade or business requirement).
Tax Planning Opportunities
- Grouping elections – obviously, owners of multiple business entities will find it impossible to be considered a material participant with respect to each activity. Taxpayers can choose to make new or revised grouping elections for similar activities in the first year they would be subject to the Surtax, generally starting in 2013 or 2014. However, this requires careful consideration of future developments. Unless your facts and circumstances change, this election is irrevocable and cannot be modified without IRS consent.
- Self-employed taxpayers – increasing your hours in an activity just to avoid the Surtax at 3.8% may subject yourself to the self-employment tax at 15.3% and obviously would prove to be costly. Keep in mind that the same item of income cannot be subject to both the self-employment tax and the Surtax. However, gains attributable to the sale of a capital asset, which are excluded from the self-employment tax, may be subject to the Surtax depending on your circumstances.
- Disposition of real estate property – this may require active real estate investors to consider how to exit their investment to minimize the Surtax, either through sale of the assets or alternatively, the owner’s equity investment. This may be particularly true for flow-through entities that have multiple business activities or for partnerships that do not have a §754 election in place.
- Estimated taxes and Alternative Minimum Tax (AMT) – starting in 2013, you must factor the additional 3.8% Surtax into your estimated payments to avoid penalties. In addition, the 3.8% Surtax is not included in your regular tax liability when determining whether AMT applies.
- Trusts – the Surtax applies to trusts as well as individuals. Rate differentials between the beneficiaries and the trust require planning to avoid the Surtax at the trust level. However, capital gains normally are prohibited from being distributed to beneficiaries. In addition, there is an ongoing disagreement as to what level the passive activity loss rules apply (trustee or beneficiary).
- Income from excess working capital – the Surtax expressly treats income derived from the investment of a business’s working capital as net investment income. For example, an LLC owns and manages a commercial office building. The LLC earns $1,000 in interest income by investing some excess cash. As a result, the Surtax will apply to each LLC member’s allocable share of the interest income, regardless of the member’s level of participation. This mirrors the treatment of portfolio income under the existing passive activity rules in §469. Proper allocations of certain qualified expenses can be used to reduce income from excess working capital.
Obviously, the Surtax presents a whole range to new issues for real estate professionals to consider. The experts at Convergence have considerable experience assisting our clients in planning how to successfully reduce or eliminate the new Surtax.
Should you have any questions about this topic of if we can improve your tax situation, please contact me at 303-951-2059 or firstname.lastname@example.org.
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
 This applies to common gains in the real estate industry, including long and short term capital gains, §1231 gains, §1245 ordinary income recapture, and unrecaptured §1250 gains.
 Work done by investors generally is not treated as participation unless the individual is directly involved in the day-to-day management or operations of the activity.
 Activities demonstrating a real estate trade or business include: advertising for tenants; speaking with potential tenants; showing properties to potential tenants; preparing leases for tenants; collecting rents; cleaning and maintaining common areas; receiving calls from tenants for repairs; paying bills; maintaining books; painting and cleaning apartment units for new tenants; and when necessary evicting tenants.