Qualifying for Real Estate Professional Status May Raise Cost-Benefits Issues, Experts Say
Reproduced with permission from Daily Tax Report, 97 DTR G-4 (May 20, 2013). Copyright 2013 by The Bureau of National Affairs, Inc. (800-372-1033) <http://www.bna.com>
Clearly defining who and what qualifies as a real estate professional and trade or business for the purpose of avoiding the 3.8 percent net investment income tax under proposed Section 1411 rules is not an easy task, and raises cost-benefit issues for taxpayers to consider before seeking to avoid it, practitioners and officials say.
The Affordable Care Act added Section 1411 to the tax code in 2010 (93 DTR G-12, 5/14/13). Among the section’s provisions is the imposition of a tax on net investment income (NII), or the unearned income or investments of certain individuals, estates, and trusts.
For individuals, the NII tax applies on income above certain thresholds, including $200,000 for a single filer or $250,000 for a married couple filing jointly. The tax went into effect Jan. 1, 2013.
Rules (REG-130507-11) proposed in November interact with Section 469 rules, including the provision that rental activities are generally a per se passive activity regardless of the level of participation, and therefore subject to the Section 1411 tax. Real estate professionals, however, receive a special carve-out under the rules.
Establishing who qualifies as a ‘‘real estate professional’’ under the rules essentially comes down to a two-part test, New York City-based practitioner Ken Weissenberg told BNA May 14. The taxpayer must spend at least 750 hours annually participating in his or her real estate trade or business to meet the material participation threshold, and the business must pass the test of a rental real estate trade or business, said Weissenberg, partner and head of accounting firm EisnerAmper’s real estate division. Real estate professionals can aggregate all of their rental activities by election under Section 469 passive loss rules to meet the threshold for establishing active participation, Weissenberg said.
Qualifying as Real Estate Profession
However, coming to a clear definition of what qualifies as a trade or business of a real estate professional under the proposed rules is somewhat more difficult, David Kirk, an attorney with the Office of Associate Chief Counsel (Passthroughs and Special Industries) at IRS, said May 10.
‘‘Not all real estate pros are created equal. There are 11 different enumerated types in [Section] 469(c)(7)(C) and there are seven different material participation tests, and so when you put that together, there are an infinite number of combinations of different things that can allow you to be a real estate pro,’’ Kirk said at a real estate panel at the American Bar Association Section of Taxation’s 2013 May meeting. Kirk was one of the principal authors of the proposed Section 1411 rules.
There are only a handful of ways that a taxpayer can qualify as nonpassive in rental real estate property, and being a real estate professional is just one of these, said Kirk. Grouping, self-rental, and other non-rental exceptions do allow taxpayers to materially participate, but ‘‘for the rank and file . . . rental is just going to be that, it’s ‘in’ ’’ for NII purposes, Kirk said.
Qualified rental real estate business also lies along a spectrum of activity, Kirk said. He gave the example of a Coldwell Banker real estate agent ‘‘building their empire one foreclosure townhouse at a time’’ and working ‘‘on the smaller end of the real estate pro world’’ that probably would not qualify as a trade or business, despite being a real estate professional. However, ‘‘on the large side, when you own one tenth of lower Manhattan with 48 different partnerships, chances are you are a trade or business,’’ Kirk said.
Additional Medicare Tax
Additionally, some real estate professionals that would appear to meet some of the Section 1411 tests would still not escape the tax include real estate managers, developers, and brokers, Weissenberg told BNA. Income derived from these activities would be subject to another Section 1411 tax, a 0.9 percent additional Medicare tax on individuals with incomes above certain thresholds, Weissenberg said.
Furthermore, income from certain rental activities are subject to recharacterization rules under the passive loss rules under Section 469 in determining whether they are included in NII, Weissenberg said. The rental income generated by a taxpayer who owns a factory building where he also manufactures widgets and leases the building to himself will be subject to recharacterization, he said.
Under the preamble to the proposed rules, a taxpayer will not be able to offset rental income derived from a real estate trade or business if he is self-renting at a loss to offset business income, Weissenberg explained. Many groups, most recently the tax section of the New York State Bar Association, have called on IRS to make the preamble a part of the final regulations (96 DTR G-3, 5/17/13).
However, if a taxpayer chooses to operate a widget factory as a tenant rather than a landlord, the income generated by the landlord may still be subject to NII unless a taxpayer can establish that the rental activity is a trade or business, Weissenberg said.
Taxpayers may be able to reduce their exposure to the Medicare surtax by availing themselves of the onetime regrouping provision within the proposed regulations that allows multiple rental activities to be regrouped as a single activity in order to pass the active real estate trade or business test, Weissenberg said.
Real estate professionals who charge fees should be aware that such income will be subject to the Medicare tax on earned income, Weissenberg said. In such cases, taxpayers must take care not to generate a loss that would be suspended under Section 469 and require them to pay tax currently on the fees, he said. ‘‘Timing is everything.’’
NII ‘Not Necessarily a Bad Thing’
Indeed, real estate professionals or other taxpayers who might meet the tests to escape the NII may want to take timing considerations on their business deals into account when deciding whether or not they benefit by escaping NII, Kirk said.
‘‘As soon as these regs came out, people started [saying], ‘I need to get my rental income out’ ’’ of NII, Kirk said. ‘‘But when the rent, when the gross [income] goes out, so do all the deductions. The question is, do you want it out?’’ Kirk asked.
Taxpayers who determine that they are not in a real estate trade or business may benefit by being able to offset their losses from their investment portfolios, he said.
‘‘But when I sell the property that’s not used in a trade or business, I’m going to pay the gain on that property as NII,’’ he said. Ultimately, the cost-benefit analysis as to whether to try to exclude activities from the NII tax comes down to where a taxpayer is in the life cycle of a real estate deal, Kirk added.
Family, Timing Considerations on Medicare Surtax
Taxpayers who wish to avoid the Section 1411 tax may consider spreading their real estate-derived income among family members, Weissenberg said.
This option is ‘‘not only an advantage from an estate planning point of view but also to the extent they have children and grandchildren who are taxed at lower brackets, [the income] might not be subject to the surtax at all,’’ if they earn below the rule’s income thresholds, Weissenberg said. Shifting ownership of real estate assets and income to the next generation can reduce the overall tax burden for the entire family, Weissenberg added.
Another option to consider for escaping the tax is the use of an installment method of sale when disposing of assets, he said. As an example, a taxpayer with a base income of $100,000 and who breaks up the sale of a real estate asset with a gain of $300,000 over a three-year period may still come in below the $200,000 threshold, Weissenberg said.
If the taxpayer picked up all of that income in one year, however, the income would exceed the $200,000 threshold of an individual taxpayer by an additional $200,000, all of which would be subject to the Medicare surtax, he explained.