Investment Analysis
Medicare Tax Concerns
How does this new law affect real estate professionals?
By William F. Becker Jr., CPA, and J. Bradley Campbell, CPA |
The
new 3.8 percent Medicare contribution tax on unearned income, effective for tax
years beginning after Dec. 31, 2012, may directly affect many owner-operators
and other real estate professionals.
Passed
by Congress in 2010 as part of the Patient Protection and Affordable Care Act,
the 3.8 percent Medicare contribution tax is imposed on the lesser of an
individual’s net investment income for the tax year or modified adjusted gross
income in excess of $200,000 ($250,000 for married couples filing a joint
return). If the Medicare surtax does apply, there is a particular impact on
real estate investors and owners.
Net
investment income includes net rental income unless it is derived in the
ordinary course of a trade or business. Because some rental income is included
in the definition of net investment income, it is important to understand the
factors that may determine the imposition of the Medicare surtax.
Grouping Properties
Historically,
qualifying as a real estate professional has generally been considered
sufficient to demonstrate that a taxpayer is actively engaged in a trade or
business and, accordingly, would not be subject to the Medicare surtax. To
avoid classification as a passive activity, the taxpayer must manage or operate
the property for more than 500 hours per year, provide substantially all of the
work required to operate the property during the year, or work more than 100
hours during the year with no one else participating in the operation more than
the taxpayer.
However,
the Internal Revenue Code specifies that each rental property is a separate
activity, which requires the above tests to be applied on a
property-by-property basis. To deal with such situations, a taxpayer may elect
under IRC Section 469(c)(7)(A) to group multiple properties into a single
activity to meet the material participation test. The properties may include
not only rental properties owned directly, but also properties owned through
partnerships or other eligible entities.
To
make the election to group properties into a single activity, a statement must
be attached to a timely filed tax return declaring the taxpayer’s intent. The
pertinent criteria are included in Reg. Section 1.469-4(c)(2).
This
grouping option is not necessarily lost if the election was not made. In 2011,
the Internal Revenue Service issued Revenue Procedure 2011-34, which allows for
a late election to be made for prior years if the taxpayer can demonstrate
reasonable cause for failing to timely file an election, the affected
properties were consistently grouped, and all earlier income tax returns were
filed timely as if the election had been made. Once made, the election is
generally irrevocable.
For
real estate professionals to avoid the Medicare surtax on net rental income,
they must not only materially participate in the operation of their properties
(so that it is not a passive activity), but their operation of the properties
must constitute a trade or business. Grouping all rental activities owned or
managed into one activity can eliminate the passive activity characterization
of the income. It can also be beneficial in demonstrating that the aggregated
activities constitute a trade or business.
Triple Net Challenges
However,
the issue is not entirely clear. Some commentators suggest that material
participation in managing properties, even where those properties are owned,
does not cause them to be engaged in a trade or business. The determination of
what constitutes a trade or business may fall under IRC Section 162 and other
established standards. Those commentators suggest that management of properties
subject to triple net leases may not constitute a trade or business and that
such leases should be changed so that the landlord actively performs or is
responsible for the performance of necessary services under the lease.
The
Medicare surtax also may not apply to “self-rented” property. When certain
criteria are met, owner-users may be able to elect to group the rental activity
with their business activity to form an “appropriate economic unit” within the
context of IRC Section 469. This grouping can cause the rental income to escape
characterization as passive income subject to the Medicare surtax.
Again,
however, it appears that the IRS may take the position that the rental income
is still subject to the Medicare surtax, because it is not derived in the
course of a trade or business. As noted above, some commentators are
recommending that leases for self-rented property not be triple net leases and
that the landlord actively perform or be responsible for the performance of the
services necessary under the lease.
Owner-operators
and other professionals in the real estate industry must now meet several tests
to substantiate that they are actively involved in a trade or business and are
not subject to either the passive activity loss limitations or the Medicare surtax
on net investment income. It is more important than ever to review all real
estate activities, evaluate the degree of participation in them, and consider
how they relate to one another. Hopefully, guidance will be forthcoming before
the filing deadlines for 2013 tax returns. In the meantime, individuals earning
income generated from rental real estate activities should consult their tax
advisers to begin planning how to minimize the impact of the Medicare surtax on
their 2013 income.
William F.
Becker Jr., CPA, is a tax partner in the Tampa,
Fla., office of Cherry Bekaert LLP. Contact him at bbecker@cbh.com. J.Bradley Campbell, CPA, is
the managing partner of the South Carolina Upstate office. Contact him at
bcampbell@cbh.com.