Investment Analysis

Medicare Tax Concerns

How does this new law affect real estate professionals?

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.

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