Higher income individuals are subject to a 3.8-percent tax on their net investment income (NII). In addition to traditional portfolio income, the NII tax applies to income and capital gain from rental real estate, unless that income or gain is derived from a non-passive trade or business. Determining whether your rental real estate activities are exempt from NII tax is more complicated than you might think. Here are several questions you need to ask:
Does the tax apply to you?
The first step is to determine whether you’re subject to the NII tax at all. The tax applies only if your modified adjusted gross income (MAGI) exceeds a specified threshold. Currently, the threshold is $200,000 for single filers and heads of household, $250,000 for joint filers, and $125,000 for married taxpayers filing separately. Generally, MAGI is equal to your adjusted gross income (AGI), unless you have foreign earned income, in which case certain adjustments are required.
The NII tax also applies to trusts and estates, but the threshold is much lower: The tax applies once undistributed AGI tops $12,400.
If you’re subject to the tax, it applies to your NII or to the amount by which your income exceeds the threshold, whichever is less. Suppose, for example, that a married couple filing jointly have MAGI of $325,000 and $100,000 of NII. Their tax liability is 3.8% of $75,000 (the excess of their MAGI over the threshold), or $2,850.
Do you have net investment income?
The next step is to determine whether you have NII that’s subject to the tax. Remember, the tax applies to net investment income, which is equal to gross investment income reduced by allocable expenses, such as interest expense, management fees, professional fees, and certain taxes. If your NII is zero or negative, then the tax doesn’t come into play.
Do you have rental income?
If your rental properties are operating at a loss, or you sell rental properties at a loss, the status of your rental activities as a non-passive trade or businesses is irrelevant for NII tax purposes. [Although it may be relevant for purposes of the passive activity loss (PAL) rules.] On the other hand, if you have rental income or net capital gains from the sale of rental properties, there may be an opportunity to reduce or eliminate NII taxes if your rental activities are properly characterized as a non-passive trade or business.
Are you a real estate professional?
For purposes of the NII tax, the character of your rental real estate activities is determined by reference to the PAL rules. Under those rules, rental real estate activities are deemed to be passive, regardless of your level of participation. There’s an exception, however, for qualified real estate professionals. To qualify, you must spend:
• More than 50 percent of your working time on “real estate businesses” in which you materially participate; and
• More than 750 hours during the year on such businesses.
Real estate businesses include development, acquisition, construction, rental operation, management, leasing and brokerage businesses. Note that services you perform as an employee don’t count toward the above thresholds unless you own five percent or more of the business.
Do you materially participate in rental activities?
Even if you’re a qualified real estate professional, your rental activities aren’t necessarily non-passive. You must also demonstrate that you materially participate in those activities, which means your involvement is “regular, continuous and substantial.” Proving materiality can be a challenge, so the tax regulations provide several objective tests you can use to demonstrate material participation. For example, you materially participate in an activity if:
• You spend more than 500 hours on the activity during the year.
• You spend more than 100 hours on the activity during the year and no other person spends more time on the activity than you.
• You’re the only participant.
• You materially participated in the activity during any five of the preceding 10 tax years.
• You spend more than 100 hours on the activity during the year, and your participation in all such “significant participation activities” totals more than 500 hours.
Although each rental property is considered a separate activity, you can elect to aggregate all of your rental properties in order to satisfy the material participation requirement. Keep in mind, however, that doing so may have other, unintended tax consequences.
Are you operating a trade or business?
To avoid NII taxes, rental income or gain must be attributable to a non-passive trade or business. In other words, it’s not enough to demonstrate that an activity is non-passive; you must also establish that it rises to the level of a trade or business.
There’s no definition of “trade or business” in the regulations; it depends on the facts and circumstances. Arguably, in most cases, demonstrating material participation in an activity should be enough to satisfy the trade-or-business requirement. In addition, the NII tax regulations also provide a safe harbor: Rental activities are deemed to be a trade or business if you participate in them for more than 500 hours or if you met the 500-hour threshold in five of the 10 preceding tax years.
What about trusts?
What if rental real estate is held in a trust? In that case, as noted above, the NII tax kicks in once the trust’s undistributed AGI exceeds $12,400. One strategy for avoiding the tax is to ensure that the trust’s rental income is treated as income from a non-passive trade or business. The U.S. Tax Court has ruled that a trust can qualify as a real estate professional and materially participate in a trade or business by virtue of its trustees’ activities. To achieve this treatment, consider naming one or more active participants in your rental real estate businesses as trustees.
Consult your advisors
The 3.8-percent NII tax may apply to rental income and to capital gains from the sale of rental real estate. You’re exempt from the tax, however, if you’re a qualified real estate professional and rental activities constitute a non-passive trade or business. Your advisors can help you determine whether you’re subject to the tax and, if so, identify strategies for mitigating it.