Just as the real estate industry is beginning to experience a long-awaited recovery, a new investment income tax is poised to lighten the wallets of many real estate investors.
Effective January 1, 2013, certain high-income taxpayers face a new 3.8 percent additional Medicare contribution tax on net investment income (the net investment income tax, NIIT). This tax will fund Affordable Care Act provisions regarding federally mandated health insurance coverage. In fact, the NIIT is projected to raise more than $210 billion over the next 10 years, representing more than half of the total new expenditures in the health care reform package.
The NIIT is an extra tax that will be imposed in addition to the regular federal income tax. Taxpayers will be subject to the NIIT if their modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers filing jointly or $200,000 for single taxpayers. The amount subject to the tax is the lesser of net investment income or the amount by which MAGI exceeds the applicable threshold.
The following types of income and gain are included in the definition of net investment income and so may be subject to the NIIT:
- Gross income from interest, dividends, annuities, royalties and rents, unless those items were derived in the ordinary course of an active trade or business;
- Other gross income from passive activities; and
- Taxable net gain from dispositions of property other than property held in an active trade or business.
A married couple filing jointly has MAGI of $350,000, and net investment income of $75,000. The NIIT is calculated on the $75,000 net investment income, since that amount is lower than the amount by which the taxpayers’ MAGI exceeds the applicable threshold ($350,000 minus $250,000 equals $100,000.) The NIIT amount would be $2,850 ($75,000 times 3.8 percent).
Planning for the NIIT
Real estate investors who find themselves at risk for the NIIT should consider the following planning moves.
Make passive activities non-passive through material participation. The ordinary course exception may be available to certain real estate investors whose rental income or gain is derived from a trade or business that is not a passive activity under the rules of Internal Revenue Code (IRC) Section 469. This two-part test deals with the following questions:
1) Is the activity conducted for income or profit, and is it engaged in with some regularity and continuity?
2) Does the taxpayer materially participate in the activity on a regular, continuous and substantial basis?
Use the “real estate professional” exception. IRC Section 469 provides certain exceptions for real estate professionals, which may allow otherwise passive rental activities to qualify as an active trade or business. In order to qualify as a real estate professional, a taxpayer must meet the following two criteria:
1) More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in “real property trades or businesses” in which the taxpayer materially participates, and
2) The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Group activities. Real estate professionals also may group certain trade or business activities for purposes of applying the passive activity rules. The grouping rules allow one or more trade or business activities or rental activities to be treated as a single activity if the activities constitute an “appropriate economic unit” for the measurement of gain under Section 469.
Use the installment method to spread out taxable gains. The entire profit from a sale generally is taxable in the year of sale. However, if one makes part of the proceeds payable in later years, only the portion of the gain attributable to the proceeds received in each year is subject to tax in that year.
Use like-kind exchanges to defer gain recognition to a lower net investment income year. Like-kind exchanges may be appropriate for taxpayers who want to realize gains on investment property this year, but defer gain recognition until a later year, when MAGI may not exceed the applicable threshold for NIIT.
Additional planning strategies that may minimize exposure to the net investment income tax include the following:
- Adjusting the timing of a home sale;
- Recognizing losses to offset earlier gains;
- Using Roth IRAs instead of traditional IRAs;
- Timing conversions of Roth IRAs;
- Timing considerations for IRA required minimum distributions; and
- Using self-directed IRAs with investments in real estate.
Taxpayers should analyze their real estate activities before the end of the year to determine their most advantageous tax planning strategies. Otherwise, the new net investment income tax could come as a very unwelcome surprise.