The Affordable Care Act (ACA) has transformed more than the nation’s health care system; its repercussions have hit the country’s revenue-collection system, the federal tax code. In order to pay for increased federal costs associated with enacting the ACA, new sources of federal revenue were created.
Net Investment Income Tax (NIIT)
One of these revenue sources is the NIIT, which will be applied at a rate of 3.8% to certain net investment income reported on your IRS Form 1040. You will owe this tax, beginning with the 2013 taxable year, if you have net investment income (NII) and also have modified adjusted gross income over $250,000 for those married filing jointly, and $200,000 for those filing single.
In general, investment income includes but is not limited to interest, dividends, capital gains, non-business rental and royalty income, and non-qualified annuities. In addition, it includes any business income from pass-through entities in which partners or shareholders are considered passive due to the lack of material participation.
Options to protect yourself through planning
The NIIT is imposed by section 1411 of the Internal Revenue Code. This is a section which has been made extremely complex by conflicting guidance offered by the Treasury. In spite of the complexities, Clark Schaefer Hackett stands ready to provide planning ideas to mitigate your exposure to this tax.
Real estate professionals and rental income
Rental income will not be subject to NIIT if it is understood to be from a business in which you materially participate as a real estate professional. Material participation is a numeric calculation performed on each business unit or company, requiring a minimum number of hours spent in each “business.” But the fixed number of hours in a year ultimately precludes a person from materially participating in more than three business units.
So if you claim income from more than three units, it may be smart for you to aggregate like entities. The result will be fewer businesses, each comprised of multiple properties, and thus you have a better chance of meeting the “material participation” bar.
For example, if you are a real estate professional and you manage twenty commercial properties, you can consider aggregating them into one business unit comprised of 20 properties. You would then likely qualify as “materially participating” as a real estate professional in this one business. And your rental income from those 20 properties would be considered business income not subject to the 3.8% NIIT.
Business owners and rental income
A similar solution exists for business owners. Take for instance the individual who operates a manufacturing company, holding three plants in separate LLC’s. This business owner could elect to aggregate the plants into one business unit and become “active” in that business. The income from the company’s rental properties would then avoid the 3.8% NIIT.
Don’t be caught off-guard
Failing to consider aggregation now could trigger a future tax you do not expect. The NIIT ignores a property’s passive-loss carry-forwards. Upon sale of that building the gain will be subject to the NIIT without offset. But if you aggregate, the property is considered an active business property. Gains from business assets are not included in the pool of income subject to the 3.8% additional tax.
No matter your prior aggregation election for tax purposes, it’s important to take the time to thoughtfully reevaluate it before the 2013 filing deadline. The new NIIT is a “material change” that provides you a window of opportunity to revisit your grouping election. While we do not have final rules, it’s reasonable to believe the window may close after 2013. So now is the time to make the aggregation election that’s appropriate for your business in light of the NIIT.
It comes down to investment vs. business
Determining if your real estate activity is a business is only the first step under section 1411. You must also consider if the rental income is investment income. Under section 1411 this can be problematic. Today’s IRS guidance on the matter confusingly refers to real estate as a both a business and an investment asset. Based on unofficial statements made by Treasury officials, it seems that the absence of clear regulations means the determination will be made on a case-by-case basis. However, properties where you provide services are not in jeopardy of being considered investments. The IRS is clear in their interpretation of these as businesses.
The triple net lease
There have been indications that a triple net lease is going to be hard to justify as a business. We suggest that investors who hold real estate in connection with a related operating company revisit their net leases, amending them to the extent possible to include the provision of services.
For example, consider a manufacturing company that leases a building from its shareholder in a triple net lease, and the property’s operating statement has rental income and interest expense. In this case, we suggest that the lease be amended to include base rent and common-area maintenance changes with a right of reconciliation. The rental property should be actively managed, with the owner providing services such as landscape maintenance, snow removal, cleaning services, etc. as pass-through expenses. This increases your chance that leasing the property will be considered a business activity.
The first step you should take
A review of your real estate activities and leases is an essential planning move you should make as soon as possible, well before you file your 2013 return. This will begin to give you and your advisor a sense of the tax liability you are facing in light of the NIIT, and will offer a starting place for an important conversation about mitigating it.
Dustin Deck is a Manager at Clark Schaefer Hackett, please contact him at [email protected] with any questions or for more information on this topic.