Higher Stakes for Tax Treatment of Rental Real Estate: Help Clients Manage Both the New Net Investment Income Tax and Passive Loss Limitations
EXECUTIVE SUMMARY * Beginning this year, taxpayers with income or loss from passive rental real estate activities face twin perils. Besides the passive loss limitation of Sec. 469 as in previous years, high-income taxpayers may now be subject to the new 3.80/0 net investment income tax on such income. * Taxpayers may be able to avoid either hazard if they can establish that they materially participate as real estate professionals in their real estate activities. A qualifying real estate professional must perform more than one-half of all personal services in real property trades or businesses in which the taxpayer materially participates. These real property activities must also total more than 750 hours during the tax year. * Taxpayers must also show they materially participated in rental real estate activities by each property separately or grouped, if they elect to treat them all as a single activity. Material participation must be established under at least one of seven tests under Temp. Regs. Sec. 1.469-5T(a). * Contemporaneous logs describing activities and recording hours spent on them, while not required, are strongly encouraged as a practical means of substantiating material participation, along with other supporting substantiating documents. ********** [ILLUSTRATION OMITTED] The Health Care and Education Reconciliation Act of 2010 (Reconciliation Act), P.L. 111-152, imposes an additional 3.8 % tax on net investment income, which includes income from common financial investments and from passive trade or business activities, including real estate rentals. Starting in 2013, this tax raises the stakes for taxpayers pursuing real estate activities, particularly rentals. It increases potential financial downs*des to pursuing passive activities or activities that the IRS may deem passive under Sec. 469. If the passive activity operates at a net loss for the year, the losses in excess of income are generally not currently deductible (deferred), and if the activity operates at a net gain, the profit can be hit with the additional 3.8% tax. Consequently, meeting the tests for qualifying as a real estate professional and material participation can be doubly important. Under Sec. 1411, enacted by the Reconciliation Act, the threshold modified adjusted gross income (MAGI) amount for the 3.8% tax to apply is $250,000 for a joint retum or surviving spouse, $125,000 for a married individual filing separately, and $200,000 in any other case. MAGI is adjusted gross income increased by foreign earned income excluded under Sec. 911(a), which is defined as net of the deductions and exclusions disallowed with respect to the foreign earned income. Net investment income is the sum of the excess of: * Gross income from interest, dividends, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities; * Other gross income derived from a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities; and * Net gain (taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities; over * Allowable deductions allocable to such gross income or net gain (Sec. 1411 (c)(1)). Passive activities under Sec. 469 generating net investment income include, notably, real estate rental activities, except for real estate rental activities of materially participating real estate professionals, as described below. Therefore, it is now all the more important for taxpayers who meet the threshold amount who are real estate professionals to be able to document and support their material participation in real estate activity, not only to preserve their ability to recognize losses from the activity but also to limit their net investment income tax liability. …