With a new year comes a new beginning. While New Year’s Day is typically viewed as a chance to start fresh and make changes in our personal lives, for many people New Year’s Day in 2013 took a different tone. Instead of focusing on making New Year’s resolutions, many Americans were focused on the “fiscal cliff” and their taxes. Lost in the “fiscal cliff” discussions, however, was the 3.8% Medicare contribution tax on net investment income introduced as part of the health care legislation in 2010, and which took effect on January 1, 2013.
Many in the real estate industry in South Florida will be surprised to learn that, not only is the 3.8% Medicare tax applicable to investment income such as interest, dividends and capital gains, but that it may also apply to rental income and other income earned in connection with a real estate business.
What Income is Subject to the 3.8% Medicare Tax?
The 3.8% Medicare tax generally applies to the investment income of taxpayers with income in excess of statutory thresholds. For this purpose, investment income is not limited to items such as interest, dividends and capital gains. It may also include (i) rental income, (ii) income from trade or business that is a “passive activity” to the taxpayer, and (ii) gain from the sale of an interest in a partnership, LLC or S corporation to the extent attributable to a business which is a “passive activity” with respect to the taxpayer.
Answers to frequently asked questions about the 3.8% Medicare tax can be found here.
Does the Tax Apply to Your Real Estate Activities?
In the real estate industry, the 3.8% Medicare tax generally will apply to rental income, gain from the sale of investment real estate (including a second home that is not a primary residence) and gain from the sale of an interest in a real estate partnership, LLC or S corporation with respect to which an individual is considered a passive owner. Many individuals in the real estate industry that are actively involved in their business may simply assume that their rental income will not be subject to the 3.8% Medicare tax. Unfortunately, without proper planning, some will be surprised to learn that their rental income is subject to this new tax.
In general, any rental activity is characterized as a passive activity and subject to the 3.8% Medicare tax. There is, however, an exception to this rule for real estate professionals that derive rental income from a trade or business so long as they satisfy certain requirements related to the level of their participation in the business. The real estate trades or businesses to which the exception may apply include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
Qualifying as a real estate professional does not, however, get you all the way there. An individual also needs to materially participate in the properties. The business of many people in the real estate industry involves multiple properties, which often makes it difficult to materially participate in each of them. Real estate professionals may want to consider the possibility of making a “grouping election” to treat all rental real estate activities as a single rental real estate activity, which may help meet the participation requirements for all of their rental properties.
With the application of the 3.8% Medicare tax on net investment income taking effect in 2013, the real estate industry will have a renewed focus on the tax implications relating to the level of participation in a real estate business, and individuals should consult with their tax advisors to determine whether they can avoid the 3.8% Medicare tax based on their active participation in real estate activities.