During the past few months, we have focused a lot of attention on Obamacare's individual and employer mandates, risk of penalties for non-participation and, most recently, delays and missed deadlines that impact you as a business owner. But aside from healthcare mandates, Obamacare also carries new tax burdens, specifically for those in higher income brackets. Most worrisome is a new 3.8% tax on various types of investment income received by individuals, trusts, and estates. This is the Net Investment Income Tax (or NIIT, a.k.a. Medicare Contribution Tax), and will be applied to net investment income in excess of certain thresholds.
Net investment income is gross investment income less deductions distributed across that income. There are 3 categories:
Traditional (i.e. interest dividends, annuity income, royalties)
Trade or business income from 'passive investments' and trading
Gains from the exchange or sale of property, including capital gain from
portfolio investments and sales of 'passive activities'
After combining income from the three categories, certain deductions are allowed to arrive at 'net investment income'. The 3.8% tax applies to the lesser of a) net investment income or b) the excess of a taxpayer's modified adjusted gross income over the applicable threshold of $200,000 for single taxpayers and $250,000 for married, filing jointly taxpayers (thresholds also exist for wills and estates in lesser amounts). Here's an example:
Jack, single, earns $190,000 in wages and $20,000 in interest income. He has no itemized deductions. His modified adjusted gross income is thus $210,000. With the threshold for singles currently at $200,000, Jack is subject to NIIT on $10,000 – the lesser of net investment income ($20,000) or income above the threshold ($10,000).
Certain types of income are excluded from the definition of net investment income including earned income, active trade or business income, distributions on retirement plans or IRAs, and gain on the sale of a primary residence (provided the gain does not exceed the current exclusion). Unfortunately, when combined, these types of income can increase the taxpayer's adjusted gross income and likelihood that NIIT will apply. Avoiding the tax altogether is extremely difficult.
For taxpayers that own real estate, pursuant to Section 469, rental real estate activities are considered passive by default. In general, any and all income
from a passive activity will constitute net investment income. In certain situations, however, you can overcome the presumption that a rental activity is passive by qualifying as a "real estate professional". If you can reach this standard the resulting income or loss will be classified as nonpassive rather than passive. This could yield significant tax savings.
To qualify as a real estate professional, you must pass the following three tests:
1. More than one half of the personal services you perform in all trades or businesses for the tax year must be performed in real estate trades or businesses in which you materially participate (you must spend more hours on real estate activities than non-real estate activities).
2. You must perform more than 750 hours of services during the taxable year in real property trades or businesses in which you materially participate.
3. Each rental activity must rise to the level of a trade or business.
There is no bright-line test for when an activity rises to the level of a trade or business. However, it is generally assumed that your rental activity rises to the level of a trade or business when your involvement in the activity is regular, continuous, and substantial. Managing multiple commercial properties and tenants would likely rise to the level of a trade or business. Renting out a single family home would most likely not.
In applying this "trade or business" standard, it appears a microanalysis of a real estate professional's various rental activities are required to determine whether any resulting income may be excluded from net investment income. This analysis is particularly important when the rental activities are owned through separate LLCs because the proposed regulations require that the determination of whether an activity rises to the level of a trade or business must be done at the entity
As with most Obamacare mandates, this one is still a bit fuzzy; the IRS has only just released a draft of instructions for carrying out NIIT. Still, it is important to prepare as best you can for changes that are already here. As we head into the final quarter of 2013, it is time to tailor a tax minimization strategy that suits your specific situation and minimizes the impact of the NIIT on your individual tax return.