Documentation is key
By now, you’ve heard about the new 3.8% net investment income tax (NIIT), also known as the Medicare contribution tax. It was created by the Health Care and Education Reconciliation Act of 2010 and took effect at the beginning of 2013. The onset of the NIIT gives some taxpayers with rental income yet another reason to seek status as a “real estate professional.”
Summing up the new tax
Beginning this year, higher-income taxpayers generally will be subject to the 3.8% NIIT on some or all of their unearned income, including income from some real estate activities and transactions. This is in addition to — and calculated separately from — the taxpayers’ regular income tax or alternative minimum tax (AMT) liability.
NIIT will be applied to net investment income to the extent that modified adjusted gross income (MAGI) exceeds the following thresholds: $250,000 for joint filers; $125,000 for married taxpayers filing separately; and $200,000 for single individuals and heads of households. Individuals who are exempt from Medicare taxes may nonetheless be subject to the NIIT if they have both net investment income and MAGI above the applicable thresholds.
Net investment income is calculated by deducting from investment income certain expenses that can be allocated to that income. Investment income includes (but isn’t limited to):
• Capital gains,
• Rental and royalty income,
• Nonqualified annuities (including payments under life insurance contracts),
• Income from businesses involved in the trading of financial instruments or commodities, and
• Income from businesses that are passive activities to the taxpayer (meaning the taxpayer doesn’t “materially participate” in the business).
Generally real estate professionals do not have to worry about being passive in their real estate activities. But if you have too many activities or investments without electing to aggregate the properties you could inadvertently find yourself as not active in some of your real estate activates. Further, as real estate developers raise capital from non-real estate owners you need to be aware of the additional cost to your investors as passive in the investment.
What is non-passive income or active real estate income:
Such income is excluded from net investment income if it’s derived in the ordinary course of a trade or business that isn’t considered to be a passive activity with respect to you.
Following the rules
“Passive activity” is defined as any trade or business in which the taxpayer doesn’t materially participate. Rental real estate activities are usually considered passive activities regardless of whether you materially participate.
But the Internal Revenue Code (IRC) recognizes an exception from restrictions on passive activity losses for taxpayers who are real estate professionals. If you qualify as a real estate professional and materially participate, your rental activities are treated as a trade or business, and you can offset nonpassive income with your rental losses. You may also be able to enjoy the added benefit of avoiding the NIIT as long as you’re engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity isn’t incidental to a nonrental trade or business).
You or your investor can qualify as a real estate professional by satisfying two requirements: 1) More than 50% of the personal services you performed in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services per year in real property trades or businesses in which you materially participate. “Real property trades or businesses” include those that develop or redevelop, construct or reconstruct, acquire, convert, rent, operate, manage or broker real property.
What counts as material participation?
According to the IRC, you materially participated in a rental activity if you satisfy one of the following tests:
• You participated in the activity for more than 500 hours during the tax year.
• Your participation for the tax year constitutes substantially all of the participation in such activity of all individuals for the year.
• You participated in the activity for more than 100 hours during the tax year, and at least as much as any other individual who participated in the activity for the year.
• The activity is a significant participation activity, and you participated in such activities for more than 500 hours. (A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t satisfy any of the five other tests.)
• You materially participated in the activity for five of the 10 immediately preceding tax years.
• Based on all the facts and circumstances, you participated in the activity on a regular, continuous and substantial basis during the year.
You can satisfy the test by electing to aggregate your rental activities, often a necessary step.
Can you prove it?
Under federal tax regulations, you can establish the extent of your participation in an activity “by any reasonable means.” Reasonable means include the identification of services performed over a period of time and the approximate number of hours spent performing those services in the period, based on appointment books, calendars or narrative summaries. While contemporaneous records aren’t required, having them will most likely help you withstand IRS scrutiny.
Aggregation to the rescue
Taxpayers who own multiple rental properties may find it difficult to satisfy the material participation requirement for each property. Fortunately, the IRC allows you to establish material participation by electing to aggregate all rental properties as a single rental activity. The election will be binding for all future tax years in the absence of a material change in facts and circumstances.
Note that the Treasury Department and the IRS have determined that taxpayers should be given the opportunity to regroup in light of the net investment income tax. Thus, proposed regulations for the new tax provide that taxpayers may regroup their activities in the first taxable year beginning after Dec. 31, 2012, in which the taxpayer meets the applicable income threshold and has net investment income.
Implement best practices for documenting your participation
Generally you, as the taxpayer, bear the burden of proving you are entitled to the deduction claimed on your tax return. Real estate pros who have successfully won their claim provided significant, credible evidence. So this step – documentation – will pay the biggest dividends if you are selected for audit.
Your objective is to overwhelm the IRS with contemporaneous documentation that identifies the nature of the services you and anyone else has performed, the time period in which they were performed, and the approximate number of hours spent performing such services.
The regulations concerning record-keeping are somewhat ambiguous, stating that participation in an activity may be established “by any reasonable means.” However, after-the-fact estimates and unsubstantiated first-hand accounts are regularly disregarded by the courts.
So it’s in your best interest that your business records capture evidence of your personal material participation in the operations of rental real estate. Appointment books, calendars, and narrative summaries (internal memoranda) can be used as evidence of participation. Likewise, reviewing, initialing, and dating tenant files, financial records, contracts, applications and other documents is an excellent method of documenting your participation.
And note, to pass the 100-hour material participation tests, you will need to show that no one else participated more than you. So if you have employees, subcontractors, or other individuals assist you in operating the rental real estate, your records will need to clearly identify how much time each individual participated in the operations.
Understand that going into the market place and using limited partnerships to attract capital will have a lager tax impact on your passive investor. The yield will be reduced by the new tax. Planning for the tax and accelerating depreciation on properties may in fact shelter your investors from the additional tax on income and increase the overall return on cash invested.
For more information contact Denice Hertlein at [email protected].
CSH’s Morgan Mahaffey, Senior Accountant, contributed to this article.