Beginning last year, a new 3.8% Medicare tax was imposed on net investment income (NII). That may be an important healthcare consideration for many, but what on earth does that have to do with commercial real estate investments? Short answer: A lot.
How This Tax Affects You
The new tax affects joint tax filers with adjusted gross income (AGI) of $250,000 and single filers with AGI over $200,000. It applies to unearned income such as interest, dividends, capital gains, annuities, royalties and rents, other than these types of income derived in the ordinary course of a non-passive trade or business. This would include income from partnerships/LLC’s and small businesses.
So how will this new tax be applied to real estate profits? In most cases income derived from rental activities will be characterized as passive, and subject to the Medicare tax. An exception to this rule relates to rental real estate professionals. A taxpayer qualifies as a real estate professional if:
- More than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
The key benefit for real estate professionals is that their income is considered non-passive by definition. For this reason, rental income received by rental real estate professionals should not be considered part of net investment income when calculating the 3.8% Medicare tax, as long as the rental real estate activities are conducted as part of a trade or business.
Real estate professional taxpayers should consider making grouping elections, which combine all rental activities into a single rental real estate activity. This may help taxpayers meet the material participation requirement for all their rental properties.
For the sale of a partnership/LLC interest, the proposed regulations assume hypothetical gains and losses on a fair market value sale of the underlying assets held by the partnership/LLC. The gain or loss on the deemed sale of an asset will not be included in the calculation of net investment income if the asset is held in a trade or business, and the owner was active with respect to that trade or business.
Net gains associated with distributions or liquidation of a partnership/LLC will almost always be treated as net investment income and will be subject to the new Medicare tax for both passive and active owners.
Deferred or excluded income items, such as from Section 1031 like-kind exchanges or gain exclusion from sale of a principle residence, are generally not subject to the tax.
However, the tax will apply to income from the sale of a principle residence above the $500,000 exclusion for married filing joint taxpayers ($250,000 if filing single). Moreover, gain from the sale of investment property or a second home, and passive income from real estate and any investment in which the taxpayer does not materially participate, are subject to the tax. [Editor’s Note: Please check with your CPA before applying any of the above information.]
Barry Slatt Mortgage is a long-standing and respected institution with more than four decades of experience in commercial mortgage banking and five offices serving California. For more information please visit www.slatt.com.