If you own real estate, will you end up having to pay the 3.8% net investment income tax (NIIT) that goes into effect in 2013 ? For purposes of this discussion let us assume that your AGI is over the relevant threshold ($250,000 in the case of a married couple filing jointly). Even if your AGI is generally low, there may come a year when you sell property, giving you a high adjusted gross income and significant income subject to NIIT in that year. So there are two important questions. Will NIIT apply to your real estate income, including gains from the sale of property ? Is there anything you can do about it ?
The answers are. Probably NIIT will apply to your real estate income and there might be something you can do about it. What you need to do is sit down with someone who understands the passive activity loss rules and consider how you might group your various holdings. It may turn out that keeping really good records of how you spend your time will help you avoid the tax. I have now reached the limit of my ability to explain this problem without going tax geeky on you. If you have significant holdings and want to try to minimize this tax, you are going to need somebody who understands you and your holdings and is geeky, because the regulations just issued require you to jump from one Code section to the next and reflect on murky definitions.
What Do The Passive Activity Loss Rules Have To Do With It ?
The passive activity loss rules (Code Section 469) were part of the Tax Reform Act of 1986. They were meant to drive the stake through the heart of tax shelters. The Section led to fairly complicated regulations and quite a bit of case law. Generally speaking, though, you only had to worry about all these rules if you had losses that you wanted to use to reduce your adjusted gross income. If everything you did was profitable, then you did not have to worry about them. Now you may. An activity that would be considered passive under 469 that produces net income will add to the amount subject to NIIT, unless it is subject to self-employment tax.
The NIIT includes “rents” among the items that it taxes. Rents are excluded from the tax base if they are derived in the “ordinary course” of a trade or business that is not subject to the passive activity loss rules of Section 469. It seems that we are at a dead end here. Rental activities are “per se” passive under 469. There is an exception though. The “per se” passive rule does not apply to real estate professionals.
What The Regulations Say About Real Estate Professionals ?
The regulations recognize that real estate professionals may be exempt from NIIT on some of their properties.
Section 469(c)(7) and Sec. 1.469-9 provide special rules for certain individual taxpayers involved in the conduct of real property trades or businesses (real estate professionals). If a taxpayer meets the requirements to be a real estate professional in section 469(c)(7)(B), the taxpayer’s interests in rental real estate are no longer subject to section 469(c)(2), and the rental real estate activities of the taxpayer will not be passive activities if the taxpayer materially participates in each of those activities. .
So You Want To Be A Real Estate Professional ?
If you have a day job outside of real estate, it can border on the impossible to qualify. The 750 hour standard is not too bad, but what kills most people is the requirement that you spend more time on your real estate activities than anything else. There was one case a little over a year ago of somebody with a serious day job who was able to pull it off. He was a harbor pilot and his piloting was on a week on week off basis. The other thing that people have a lot of trouble with is having good records of how they spend their time. Both the IRS and the Tax Court are very hard on people who don’t keep contemporaneous records.
There is a whole new class of persons who are going to be looking to gain the status. That would be real estate owners whose properties have been consistently profitable. The “per se” passive rule never mattered to them. If the properties have been profitable enough to keep them from needing day jobs, they might be able to qualify now. It is critical, though, that they document their time to make that 750 hour bogey.
Qualifying as a real estate professional does not get you all the way there. That just gets you around the “per se” passive rule. You also need to materially participate in your properties. Of course if you have multiple properties, it may be impossible to materially participate in each of them. You are allowed to elect to aggregate your properties for that purpose, but you must make the election. Many people miss it.
Do You Have A Trade Or Business ?
There is another curve ball to this.
However, a taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business (within the meaning of section 162) with respect to the rental real estate activities. If the rental real estate activities are section 162 trades or businesses, the rules in section 469(c)(7) and Sec. 1.469-9 will apply in determining whether a rental real estate activity of a real estate professional is a passive activity for purposes of section 1411(c)(2)(A). However, if the rental real estate activities of the real estate professional are not section 162 trades or businesses, the gross income from rents derived from such activity will not be excluded under section 1411(c)(1)(A)(i) by the ordinary course of a trade or business exception.
You would think that somebody could be able to tell right off whether a particular real estate activity constitutes a trade or business. It is usually quite important whether an activity is a trade or business. For most activities, whether deductions go against adjusted gross income will hinge on the “trade or business” question. Also, trade or businesses are generally subject to self-employment tax. When you get to rental real estate activities though the “trade or business” question becomes less important. Related deductions go against adjusted gross income, regardless. Real estate rentals are specifically excluded from self-employment tax.
Well now if you are a real estate professional, the NIIT makes the question important. The IRS is putting us on notice in the regulations that they are going to be looking at it. I’ve spent a little bit of time poking at the question and my first impression is that it is something of a gray area. To illustrate the problem let’s consider someone who owns his own real estate brokerage firm. The brokerage firm will qualify him as a real estate professional.
Suppose our broker owns a building that is triple net leased to a credit tenant for a very long term. He will probably not be able to get out from paying NIIT on the income stream from that property. If on the other hand he owns a few three-deckers and deals with the tenants himself, by jumping through the proper hoops he can avoid NIIT on the income from the housing units. Perhaps more significantly, any gain from a sale will not be subject to NIIT. An intermediate case might be one like the situation I find myself in – an accidental landlord. I continue to own a former residence and am renting it out till housing prices recover or hell freezes over. It is a matter of indifference to me as to whether that rental counts as a trade or business. If I were a broker, it would be a different story.
There’s More
The regulations on the NIIT have a lot more wrinkles to them. They will require people with multiple activities to look closely at how they are classified. In the past having a profitable activity classified as passive under 469 was either a good thing or a matter of indifference. It would be a good thing, if you had losses from other passive activities. Thanks to NIIT, it is no longer such a good thing.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Dec 10th, 2012