Affordable Care Act Generates a New Opportunity for Real Estate Professionals

Final regulations have recently been issued for the 3.8% net investment income tax (NIIT) under the Patient Protection and Affordable Care Act of 2010 (ACA). This new surtax became effective in 2013, imposing a new tax on the net investment income of individuals as well as trusts and estates. The purpose of the surtax is to tax “unearned” income, such as interest, dividends, annuities, royalties, and rental income from passive activities.

Fortunately, real estate professionals who materially participate in rental activities have the ability to exclude rental income from the imposition of the NIIT. In order to qualify for the exclusion, rental income associated with real estate must be earned in the “ordinary course of a trade or business.” This additional requirement places a responsibility on real estate professionals (and on their tax advisors) to prove rental income can be excluded from the surtax.

The good news is that the recent, and final, IRS regulations contain a “safe harbor” test to relieve this burden. Those real estate professionals who participate in rental real estate activities for more than 500 hours per year -- or for more than 500 hours in five of the past ten years -- will have rental income that is presumed to be derived from the “ordinary course of a trade or business.”

Although the final regulations are not effective until 2014, the IRS indicates that real estate professionals may rely on the new safe harbor in excluding income from the NIIT on their 2013 returns.

Of course, a taxpayer who does not meet the 500-hour requirement can still take the position that his or her rental activities are earned in the “ordinary course of a trade or business.” However, the burden will be on the taxpayer to show that his or her involvement in the real estate was regular, continuous, and substantial enough to meet this threshold.