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.
Here’s where the new regulations help real estate professionals out. They establish a “safe harbor” rule for when a rental activity conducted by a real estate professional is a business: So long as a real estate professional devotes a minimum of 500 hours per year in the rental activity, it will automatically qualify as a business for these purposes and the rental income will not be subject to the NII tax.
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.
Stephen Fishman is a tax expert, attorney, and author who has published 20 books, including “The Real Estate Agent’s Tax Deduction Guide,” “Working for Yourself,” “Deduct It!,” and “Working with Independent Contractors.” His website can be found at fishmanlawandtaxfiles.com.