Starting in 2013, a new 3.8 percent Medicare tax will be imposed on investment and rental income earned by higher-income taxpayers. Funds from the tax will be used to help pay for the nation’s financially troubled Medicare program.
This is a major change in the tax law that will affect many landlords. For higher-income taxpayers, it will make rental property a less attractive investment than it used to be.
However, most real estate professionals who own rental properties will be exempt from this tax.
Here are the basics about the new tax you should understand now.
Only high-income taxpayers affected
The new tax applies only to people with relatively high incomes. If you’re single, you must pay the tax only if your adjusted gross income (AGI) is more than $200,000. Married taxpayers filing jointly must have an AGI over $250,000 to be subject to the tax. Your adjusted gross income is the number on the bottom of your IRS Form 1040. It consists of your income from almost all sources, including wages, interest income, dividend income, income from certain retirement accounts, capital gains, alimony received, rental income, royalty income, and unemployment compensation, reduced by certain "above the line" deductions such as IRA contributions and one-half of self-employment taxes.
Only net investment income is taxed
The new Medicare tax is imposed only on a taxpayer’s net investment income. Investment income consists of interest, dividends, royalties, annuities, and rents not derived from an active trade or business, any other gain from a passive trade or business, and taxable gains from the sale or other disposition of investment property.
The new Medicare tax applies to rental income
Your net rental income is subject to the tax unless you qualify for the real estate professional exemption discussed below. Your net rental income consists of your gross (total) rents minus all deductible expenses you incur in operating your rental property. Your deductible expenses for these purposes will generally be the same as shown on your Schedule E.
For example, if you earn $200,000 in gross rents during 2013 and have $100,000 in expenses, you’ll end up with $100,000 in net rental income that must be included in your adjusted gross income. If you have a net loss from your rental activities, you can use it to reduce your AGI subject to the passive loss rules. This makes the rental property deductions available to landlords more valuable than ever.
Tax is imposed on only a portion of investment income
The Medicare tax is a 3.8 percent tax, but it is imposed only on a portion of a taxpayer’s income. The tax is paid on the lesser of (1) the taxpayer’s net investment income, or (2) the amount the taxpayer’s AGI exceeds the applicable AGI threshold ($200,000 or $250,000).
Example: Phil and Penny are a married couple who file a joint return. Together they earn $200,000 in wages. They also earn $200,000 in net rental income and $150,000 in other investment income. Their AGI is $550,000, including $350,000 in net investment income. They must pay the 3.8 percent Medicare tax on the lesser of (1) their $350,000 of net investment income, or (2) the amount their AGI exceeds the $250,000 threshold for married taxpayers — $300,000. Since $300,000 is less than $350,000, they’ll have to pay the 3.8 percent tax on $300,000. Their Medicare contribution tax for the year will be $11,400 (3.8 percent × $300,000 = $11,400).
At most, you’ll have to pay the tax on the portion of your AGI that exceeds the $200,000 or $250,000 thresholds.
Real estate pros can be exempt
Landlords who qualify for the real estate professional exemption are specifically exempted from the new Medicare tax. (IRC §1141(c).) This includes full-time landlords, and many part-time landlords who engage in other real estate businesses such as real estate brokerage or development. This makes the real estate professional exemption more valuable than it has ever been.
To qualify for this exemption, you must "materially participate" in your rental activity. This requires that you work a certain number of hours at your rental activity during the year. For example, you would materially participate if you work at least 500 hours during the year at the activity. You can qualify in other ways as well.
If you own more than one rental property, you are required to materially participate for each rental property you own unless you file an election with the IRS to treat all your properties together as one, single activity. This way, you can combine the time you spend working on each rental property to satisfy the material participation test.
If you fail to file the election, you’ll have to materially participate for each rental property you own. For most landlords, this is impossible to do, which makes filing an election very important.