Starting with taxes for 2013, a 3.8 percent Medicare tax applies to net investment income for some.
Net investment income is net investment after deductions properly allocable to that income.
Leonard W. Williams
The Medicare tax applies to investment income exceeding one’s “modified adjusted-gross income.”
That threshold is $250,000 for married taxpayers filing jointly; $125,000 for married taxpayers filing separately; and $200,000 for all others.
Investment income includes income earnings from interest, dividends, royalties, rents, and net gains from the disposition of property. It does not include income derived in the ordinary course of a trade or business.
Individuals whose rentals show either a loss or a -0- on their income tax returns are not affected by this.
The Internal Revenue Code isn’t consistent or helpful in that regard, since it considers rental property operations to be a business.
Simply look at Page 1, Schedule E of your 2012 Form 1040. If it’s a -0- or negative number, then your rental income isn’t affected by the change. Other items on your income tax return may be affected, but those aren’t discussed here.
The next question is whether one’s rental operations constitute a business — making them exempt from this new 3.8 percent tax — or serve as a passive investment, making them fair game.
The Internal Revenue Code isn’t consistent or helpful in that regard, since it considers rental property operations to be a business for some purposes but not for others.
The IRS, however, eventually issued some guidance in that determination, and the net profit from a rental activity will be non-passive when the realty rented is:
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Property owned by a “real estate professional” (defined later in this article) who materially participates in the management of the property.
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A property rented to a business in which the taxpayer materially participates.
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A short-term rental, i.e. one rented out for periods averaging seven days or less, in which the taxpayer materially participates.
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Property with a basis less than 30 percent of which is depreciable (e.g. vacant land)
Of the four categories just listed, this article will only deal with the first one.
The mere fact that one doesn’t fall in the safe harbor doesn’t prohibit one from considering his or her rental or rentals as a business
Toward the end of November, the IRS issued Regulations under Sec. 1411 of the Internal Revenue Code, providing a “safe harbor” for those wishing to establish their rentals as a business, and not a passive investment.
The mere fact that one doesn’t fall in the safe harbor doesn’t prohibit one from considering his or her rental or rentals as a business, but that self-determination is subject to challenge by the IRS.
On the other hand, if one alleges that he or she is within the safe harbor, then all that the taxpayer has to do is to show that his or her activities fit within the criteria laid out by the regulation.
A “real estate professional” is defined as someone who meets the following criteria:
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More than 50 percent of the taxpayer’s personal services during the year must be performed in real property trades or businesses in which the taxpayer materially participates.
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The taxpayer must perform more than 750 hours of service in this same trade or business. The IRS requires that contemporaneous (as opposed to reconstructed) time records must be maintained to prove the 750 hours.
In addition — and this is important — 1099-Misc. forms must be filed for payments to unincorporated independent contractors who were paid $600 or more for services during the year.
Because of a change in recent years, taxpayers who are not claiming real estate professional status no longer have to file 1099-Misc. forms under those circumstances.
If all of this seems mind-numbingly complicated, it’s because it is, although at least Congress has quit calling its annual tax law changes the “Tax Simplification Act of 20XX,” since they’re well along the path of simplifying it beyond all comprehension.
To close on a lighter note, here’s a true story about a court case from the early 1980’s, which illustrates the lack of common sense in the Internal Revenue Code.
A taxpayer netted her interest income against her investment expenses, which isn’t the way that the Internal Revenue Code specifies that it must be done. She was audited, and the IRS auditor disallowed her actions. She sued the IRS, believing she acted in “common sense.” The judge disagreed and said, “Unfortunately, common sense and tax law are rarely even waving acquaintances.” (Cited at 49 AFTR 2d, 82-1080)
Leonard W. Williams is a certified public accountant. The information contained in this article represents the opinions of the author and not necessarily those of the California Apartment Association. For additional information on the advice in this article, please contact Mr. Williams at williams@lwwilliamscpa.com.