Last
week the IRS issued its final
regulations governing
how it will implement a new “Obamacare tax” that imposes a 3.8
percent levy on unearned income.
Taxpayers
are subject to the Net Investment Income (NII) tax if their adjusted
gross income (AGI) for the year exceeds $200,000 for singles, or
$250,000 for marrieds filing jointly ($125,000 for marrieds filing
separately).
If
your AGI exceeds the applicable threshold, you’ll have to pay the
NII tax on the lesser of (1) your net investment income, or (2) the
amount that the your AGI exceeds the $200,000/$250,000 threshold.
“Unearned
income” means income from all “passive” activities, including
interest, dividends, annuities, royalties and rents. It does not
include income from an actively conducted business.
However,
it includes income from real estate rentals, even those that qualify
as businesses, because rental income is always deemed to be passive
income for tax purposes. Thus, landlords with profitable rentals
whose AGI exceeds the threshold will be subject to the 3.8 percent
tax on their rental income.
However,
there is one lucky group of landlords who can avoid the NII tax on
rental income: real estate professionals. As I explained in a prior
article (“It
pays for landlords to qualify as ‘real estate professional‘
“), the NII law provides a special exemption for them. They are not
subject to the 3.8 percent tax on rental income if they “materially
participate” in the real estate activity, and the activity
qualifies as a business for tax purposes.
-
IRS
regulations have long provided clear guidance on what constitutes
“material participation” in an activity. For example, you
materially participate if you work more than 500 hours at the
activity during the year, or work 100 hours and more than anyone
else. However, there have never been any clear bright-line rules on
when a real estate activity qualifies as a business rather than an
investment.
It
should go without saying that all real estate professionals who own
rental properties should be keeping careful track of the time they
spend dealing with their rentals and all their other real
estate-related activities."
Alternatively,
if a real estate pro has participated in rental real estate
activities for more than 500 hours per year in five of the last 10
tax years, the rental activity will qualify as a business. (IRS Reg.
Sec. 1.469-5T.)
If
you have more than one rental property, you are allowed to group your
rental activities together for these purposes. This way, you can
combine the time you spend working on each rental property to satisfy
the material participation and 500-hour tests. You must file an
election with the IRS to group your rental activities.
The
500-hour rule is a safe harbor, not a minimum requirement. Thus, you
don’t absolutely have to work a minimum of 500 hours per year at
your rental activity for it to qualify as a business. You can work
less hours and still qualify as a business.
But,
in the event of an IRS audit, whether you qualify will require a
judgment call by the IRS after looking at all the circumstances
involved. However, the preamble to the new regulations provides that
ownership of even a single rental unit can qualify as a business.
But, again, this depends on the circumstances — for example, the
type of property, number of units, and the day-to-day involvement of
the owner or its agent.
It
should go without saying that all real estate professionals who own
rental properties should be keeping careful track of the time they
spend dealing with their rentals and all their other real
estate-related activities.
For
more information contact
Jerry
Gusman
The
Gusman Group
(888)
213-4208
Jerryggroup@aol.com
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