As part of the financing of Obama Care, Congress created Internal Revenue Code Section 1411, which created a new 3.8% Medicare tax. The new Medicare tax took effect on January 1st and will apply to net investment income of individuals with a modified adjusted gross income of at least $200,000 ($250,000 for couples filing jointly).
The tax will apply to the lesser of:
- The taxpayer’s total “net investment income” for the year or
- The amount by which the individual’s total income exceeds $200,000 (or $250,000 for married couples filing jointly).
This new tax will hit real estate investors hard.
Investment Income Includes Rental Income
Under the new code provision, “net investment income” is defined to include gross rents. Even though gross rents are subject to the new Medicare tax, the gross rents can be reduced by deductions properly allocable to the rents. We expect that this will allow an individual to deduct depreciation, interest expense, property taxes, insurance payments and other rental property expenses before determining the amount of gross rents subject to the new Medicare tax (although it does cause concern that Congress used the term “gross rents,” if it is actually intended to mean “net” rents).
Exception for Real Estate Professionals
One way to avoid the tax is for a taxpayer to qualify as a real estate professional and for the taxpayer to materially participate in the real estate activities that generate the rental income. To be a real estate professional, a taxpayer must:
- Spend more than half her time in real estate businesses and
- Perform more than 750 hours of service per tax year in the real estate business
Real estate businesses include businesses that participate in rental, leasing, real property development, construction, acquisition, conversion, operation, management or brokerage activities. But any services performed by a taxpayer in a real estate business as an employee will not be counted toward meeting the “real estate profession” participation requirements unless the taxpayer is also at least a five percent owner of its employer.
A taxpayer will be treated as materially participating in the real estate activities that generate the rental income if the taxpayer:
- Provides at least 501 hours of service to the business during the tax year
- Provides substantially all the services for the business (after evaluating participation from non-owners or
- Provides at least 101 hours of service to the business during the tax year if no other person provides more service to the business (after evaluating participation from non-owners).
For example, a real estate professional who also individually owns 35 rental properties but hires a property manager and performs very few services related to the rental, operation or management of the properties will not have materially participated in the activities that generated the rental income and may therefore be subject to the new Medicare tax.
The real estate professional exception is narrow, but many real property developers, property managers and brokers who own their own companies and also materially participate in the management and operation of their own rental properties will not be subject to the new Medicare tax. This also means that the rental income for any taxpayer who is not properly classified as a real estate professional will be “net investment” and may be subject to the new Medicare tax.
Application to Entities
Although the new tax applies to individuals, but not to partnerships, limited liability companies or corporations, taxpayers that own real estate investments indirectly through an entity will not avoid the new Medicare tax. With respect to corporations (including S corporations), the dividends received by a shareholder will automatically be “net investment income” unless the shareholder materially participates in the business (regardless of whether the corporation owns real estate or not) and may be subject to the new Medicare tax. Similarly, the partner who does not materially participate in the rental business of the partnership will be “net investment income” and may be subject to the new Medicare tax.
Investment Income Includes Gain on Sale of Real Estate
The new Medicare tax casts a wide net to tax rental real estate income and capital gains on sale. In addition to applying to “gross” rents after deductions, the new Medicare tax also applies to the net gain on the disposition of any real property not held in a real estate business. This means that gain on the sale of a principal resident may be subject to the new Medicare tax to the extent the gain is not sheltered by the principal residence exclusion. This also means that the gain on the sale of appreciated rental property may also be subject to the new Medicare tax unless the gain on the sale is not recognized, for example, as a result of a taxpayer’s completing a Section 1031 exchange.
Two of the most important changes, which affect both apartment firms and employees, concern the Medicare tax rate and applicability. Under the new rules, an additional 0.9% Medicare payroll tax will be applied to wages for individuals earning more than $200,000 and married couples earning more than $250,000. Unlike the old law, which imposed a 2.9% Medicare payroll tax on all wage income (shared equally between employee and employer) employees will be solely responsible for the additional tax increase.
In addition, while no Medicare payroll tax today applies to net investment income – including annuities, capital gains, interest, dividends, royalties and rents – the new health care reform legislation will impose a 3.8 percent tax on such income for high-income earners. However, certain caveats apply – one of the most important being that the new tax applies only to passive investment income.
Reprinted with permission of the Arizona Multihousing Association.