There has been a lot of discussion surrounding the Obama administration’s enactment of the 3.8 percent Medicare surtax, which was designed to be assessed on a taxpayer’s net investment income. When you think about what constitutes “investment income,” traditional income from investments such as interest, dividends, and capital gains typically comes to mind. However, in some cases the Medicare surtax may also apply to net rental income, net income from a trade or business that qualifies as a “passive activity,” or the sale of partnership and LLC interests in which the taxpayer is a “passive” investor. Sales of principle residences and other real estate may be subject to the surtax as well.
When it comes to real estate, there is a major difference in terms of whether any one investor will be subject to the new tax. As mentioned above, rental income can be considered passive or active and the surtax can be assessed on income from both passive and active rental activities. However, rental income from individuals that are qualified real estate professionals (according to the IRS framework) and materially participate in the business will not have their net rental income viewed as investment income, and therefore will not be subject to the Medicare surtax.
How do you know if you qualify as a materially participating real estate professional?
The IRS has laid out several requirements to determine a professional’s status when it comes to real estate. It can be tricky to satisfy the requirements if you have several properties; there are just too few hours in the day. Therefore, real estate professionals often file a “grouping election,” which allows the IRS to look at all of the properties as a group and satisfy the requirements as an individual at the group level. Materially participating real estate professionals will likely see their net rental income shielded from the surtax due to this classification.
Who is not shielded from the surtax?
Regular rental property owners who spend the majority of their time working in other fields will be subject to the surtax to the extent they have net investment income (rental or otherwise) and adjusted gross income (AGI) that exceeds the thresholds set forth by the IRS: $200,000 for single filers and $250,000 for joint filers.
Transactions involving real estate may also be subjected to the surtax. For example, the sale of your principle residence can be excluded from capital gains treatment to the extent that the gain does not exceed the exclusion amount ($250,000 for single filers and $500,000 for married filing jointly). But when the gain from the sale of a home exceeds the exclusion amount, there will not only be a reportable capital gain on the sale, but a portion, if not all, of the gain will be subject to the 3.8 percent Medicare surtax as well.
It is important to remember in this scenario, as well as the others mentioned, that the Medicare surtax will only affect individuals whose income exceeds the thresholds for AGI.
While it has always been important for those who do business in real estate to stay well-versed on the ways the IRS views and classifies their activities, it is even more critical now in light of the additional Medicare tax.
Kelly A. Galardi can be reached at Email or 215.441.4600.