Net investment income, as defined within the US Internal Revenue Code, includes interest, dividends, annuities, royalties, rents, and certain net gains attributable to the disposition of property, among other items. One of the provisions within The Affordable Care Act imposes a tax on net investment income, effective January 1, 2013. The tax applies to individuals, as well as, some trusts and estates.
As noted above, net investment income includes rental income, which is generally considered a passive income for most taxpayers. The imposition of the new 3.8% tax upon passive income can be significant for rental property owners. However, relief exists in the form of a certain election should a taxpayers real estate investments be considered active rather than passive.
Activities which generate passive income can be combined for tax purposes and treated as a single activity which is non-passive, and thus not subject to the net investment income tax. If more than 50% of the taxpayer’s personal service time in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates, and more than 750 hours per year are spent by such taxpayer in real property trades or businesses in which the taxpayer materially participates, the taxpayer can elect to treat all interests in real estate undertakings as a single activity. By making this rental real estate aggregation election, the taxpayer can ensure that the income from the combined rental activities will not subject to the net investment income tax.
For those taxpayers who own interests in real property, in which the rental income is truly a "passive" source of income, meaning that it is not part of their regular trade or business, the rental income will be treated as part of net investment income and will be subject to the 3.8% tax. Other taxpayers who spend substantial time working in activities related to rental real estate and maintain that the income derived from rents is not passive, should not be subject to the 3.8% net investment income tax. These "real estate professionals" substantiate that the rental income should not be included as part of net investment income by choosing the following options:
- Ordinary Course Exception
The proposed regulations state that either a trade or business which is a passive activity with respect to the taxpayer, or the trading of financial instruments or commodities, is subject to the net investment income tax. To the extent investment income is derived in the ordinary course of a trade or business that is not a passive activity or a trading business, however, it is excluded from the net investment income tax altogether. A trade or business, as it pertains to the net investment income provisions, is described as either:
- a trade or business which is passive activity with respect to the taxpayer, or
- a trade or business of a trader trading in financial instruments or commodities, regardless of whether the taxpayer is active or passive in that trading business.
- Real Estate Professional Exception
Generally, rental activities are classified as passive activities, except for those of individuals classified as real estate professionals. If a taxpayer qualifies for this exception, the presumption that rental activities are passive does not apply. Instead, the rental activities will be considered as non-passive if the taxpayer can meet the requirements of being considered a real estate professional.
To the extent investment income is derived in the ordinary course of a trade or business that is neither a passive activity nor a trading business, it is excluded from net investment income altogether. Because the Ordinary Course Exception does not apply to passive trade or business activities with respect to the taxpayer, all investment income is subject to net investment income tax. The business concept serves two important functions in the Proposed Regulations. First, it limits the Ordinary Course Exception, because investment income does not qualify for the exception. Second, all other gross income that is not an investment income is included in the other income bucket and is subject to net investment tax. Thus, under the Ordinary Course Exception, Investment income is exempt from net investment income tax if it is derived in the ordinary course of a non-passive trade or business activity.
In summary, a taxpayer qualifies as a real estate professional if:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the year are performed in "real property trades or businesses" in which the taxpayer materially participates (known as the 50% test), and
- The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
- In applying the 50% and 750 hours tests, services performed as an employee are not treated as performed in real property trades or businesses unless the employee owns at least 5% of the stock (for a corporate employer) or 5% of the capital or profits interests (for a non-corporate employer).
Taxpayers must be diligent in documenting the time spent as a real estate professional as under audit, the IRS will likely request support for the 50% and 750 hour tests. A calendar documenting the time spent will be very useful in case of IRS scrutiny.
With the application of the 3.8% Medicare tax on net investment income taking effect in 2013, real estate professionals will have a renewed focus on tax implications relating to the level of participation in real estate businesses. Individuals should consult with their tax advisors to determine whether they can meet the requirements of this election and not be subject to the 3.8% Medicare tax.