If you own real estate that generates income, you could be paying an additional 3.8% net investment income tax (NIIT) which goes into effect in 2013. For the sake of discussion, let's assume that your adjusted gross income (AGI) is over the relevant threshold ($250,000 in the case of a married couple filing jointly). Even if your AGI is generally low, there may come a year when you sell property, giving you a high adjusted gross income and significant income subject to NIIT in that year. Is there any tax planning that can be done to offset the NIIT?
First, we need to understand the regulations that have been in place for real estate activities. These regulations are referred to as the passive activity loss rules (Code Section 469). They were part of the Tax Reform Act of 1986, and were meant to put a stop tax shelters. However, Section 469 led to fairly complicated regulations. Previously, you only had to worry about these rules if your real estate activity had losses that you wanted to use to reduce your AGI. If your real estate activities have been profitable, then you likely have not heard of these regulations. Now these rules may be more relevant to your profitable real estate activities. An activity that would be considered passive under Section 469 that produces net income will add to the amount subject to NIIT.
The NIIT includes "rents" among the items that it taxes. However, it appears that rents are excluded from the tax base if they are derived in the "ordinary course" of a trade or business that is not subject to the passive activity loss rules of Section 469. Rental activities are considered passive under IRC 469. There appears to be an exception: The passive rule does not apply to "real estate professionals" (see, "Are You a 'Professional'?" (March 23, 2011) at ORBA Blog, which provides a basic understanding of what it means to qualify as "real estate professional").
To be a "real estate professional," simply owning and managing multiple real estate activities may not be enough to treat a real estate activity as non-passive. You need to "materially participate" in each of the activities. The term "materially participate," for IRS purposes, consists of seven different, specific tests of which only one needs to be met (see, "Are You a 'Professional'?" (March 23, 2011) at ORBA Blog). The activities in which you do not "materially participate" will not be treated as non-passive under the real estate professional rules.
There is an election that can be made to group rental activities to (possibly) meet the material participation requirement to be considered a "real estate professional." If you do not meet the material participation tests for each separate rental property, then a valid grouping election can be made which considers your material participation in the aggregate. In the past, this has been a tax planning strategy to allow an individual to meet the real estate professional rules where there have been disallowed losses. The annual rental losses would then be allowed, despite the unavailability of any passive income since this "group" of rental properties is not subject to the passive activity loss rules. The tax planning now extends to individuals that have rental income (not just losses). According to how the regulation is currently being understood, if you instead have any net rental income from this group of rental activities, the "real estate professional" designation is considered to involve the "active conduct of a trade or business," it would not be included for purposes of calculating NIIT otherwise subject to the 3.8% NIIT (assuming you are over the AGI threshold).
The AICPA also takes the same position with regard to "real estate professionals" who otherwise avoid the passive activity loss rules on rental properties that they own because they "materially participate." In published guidance, they state that "rents are subject to the 3.8% NIIT unless the rent is derived in the ordinary course of a trade or business." Therefore, "investors in real estate would have more reason to look at the active real estate investors' rules to determine if they could avoid this tax via the active classification" (e.g., as a "real estate professional"). Thus, real estate investors need to consider the possibility of making an [grouping] election to treat all interests in rental real estate as one activity, thereby aggregating all real property interests into one trade or business" (i.e., so as to be able to meet at least one of the "material participation" standards).
If you have real estate activities with income, then the 3.8% net investment income tax may be avoided if you take some time do the tax planning.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
