4 Things real estate professionals should know about the 3.8% Medicare surtax

Starting in 2013, high-income taxpayers will face a 3.8% additional Medicare contribution tax on net investment income, known as the net investment income tax or NIIT. Here’s an overview of the new tax, along with steps you can take, as a real estate professional, to reduce its impact.

1. The NIIT is an extra tax that is imposed in addition to your regular income tax.
You will be subject to the NIIT only if your modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers filing jointly and surviving spouses; $125,000 for married taxpayers filing separately; or $200,000 for unmarried taxpayers and heads of household. The amount actually subject to the tax is the lesser of your net investment income or the amount by which your MAGI exceeds the applicable threshold.

2. The following types of income and gain (net of related deductions) are included in the definition of net investment income and so may be subject to the NIIT:
(1) Gross income from interest, dividends, annuities, royalties, and rents, unless those items were derived in the ordinary course of an active trade or business; (2) other gross income from passive activities; and (3) taxable net gain from dispositions of property other than property held in an active trade or business.

3. There are also major categories of income that are exempt from the NIIT.
Any item that is excluded from income for income tax purposes is likewise excluded from the NIIT. This means that tax-exempt interest and the excluded gain from the sale of your main home aren’t subject to the tax. Distributions from qualified retirement plans, including individual retirement accounts (IRAs) and Roth IRAs, aren’t subject to the NIIT. Wages and self-employment income aren’t subject to the NIIT, though they may be subject to a different Medicare surtax.

4. It’s important to remember the NIIT applies only if you have net investment income and your MAGI exceeds the applicable thresholds discussed above.
If you are a real estate professional, which the IRS defines as 1) spending more than half of your working hours on real estate activities and 2) you spend at least 750 hours working on real estate, you may be able to remove your rental income from the NIIT calculation.

An important concept to remember:
You have the ability to group multiple trades, businesses or rental activities together to meet the hourly requirements to make the activity non-passive.

How do I know if an activity is active or passive?
In determining whether an activity is active or passive, there are rules governing what constitutes an “activity” and how different activities are aggregated. The general passive activity loss (PAL) rules give some leeway to group trades, businesses or rental activities together to satisfy the material participation standards and avoid characterization of activities as passive. In general, a taxpayer’s initial grouping of activities can’t be changed unless the prior grouping is clearly inappropriate or if there is a material change in facts and circumstances. However, recognizing that the activity groupings that are used for regular PAL purposes now also apply for NIIT purposes, proposed regulations issued by the IRS allow you to make a “fresh start” by regrouping activities.

Should I change my grouping election?
You have a small window (2013 and 2014) to change your grouping election. You can make the regrouping election in 2013 if you are subject to the NIIT in 2013. If you don’t make the election for 2013, and the final regulations contain the same or a similar election, you may make the election for the first tax year beginning after 2013 that you are subject to the NIIT. Only one regrouping is permitted, and it is effective for all subsequent years.

Please keep in mind, however, that although the regrouping privilege can be used to treat net income from the newly combined group as non-passive business income and avoid the NIIT on that income, this can have the negative effect of transforming passive income that can be offset with passive losses into non-passive income that can’t be offset by passive losses.

Is net rental income from self-rental subject to the NIIT?
It appears that net rental income from a self-rental situation will be subject to the NIIT. A self-rental occurs when property that you own is rented for use in a trade or business activity in which you materially participate. If this is the case, the net rental activity income for the year from that property is treated as non-passive income, even though rental income is generally passive. Despite this, the income is still subject to the NIIT, because rents are considered investment income even though the income is non-passive.

However, there may be planning opportunities as a result of the grouping rules discussed above. There are situations where the rental activity and the business activity in a self-rental situation can be grouped together under the passive activity rules, but it isn’t clear from the IRS regulations if making this grouping election removes the rental income from net investment income.

As you can see, the NIIT may have a significant effect on your tax picture going forward. If you think you may be subject to the tax, be sure to meet with your tax professional to plan for these changes in 2013 and beyond.

Judd Nordquist, CPA, is AEM’s Construction/Real Estate Industry Leader. When he’s not hunting down ways to help clients improve their bottom lines, he’s hunting for pheasants with his trusty canine companion. Judd can be reached at 952.939.3204 or judd.nordquist@aemcpas.com.