By now, much has been written about the new tax landscape and the tax-mitigating strategies for reducing what you will likely owe Uncle Sam when the current tax year comes to a close in December.
A big kick in the shins was the 3.8% surtax on net investment income that took effect in 2013, courtesy of the Affordable Care Act, a.k.a. Obamacare. This tax now applies if you have both net investment income (NII) and modified adjusted gross income (MAGI) of at least $200,000 as an individual taxpayer or $250,000 as a taxpayer filing jointly.
NII includes items like interest, dividends, capital gains, rental and royalty income, and certain income from businesses. It does not include wages, unemployment compensation, and operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest or self-employment income.
Generally, under Section 469 of the Internal Revenue Code, all rental real estate activities are deemed passive by default. Thus any rental income earned is considered passive income and counts as NII toward the 3.8% surtax.
But for some taxpayers who make their living in real estate development or construction, it is possible to make the case that rental activity is non-passive by qualifying as a real estate professional. “But wait,” you say. “How can I claim to be a real estate professional if I don’t have a broker’s license?”
It turns out that the Code’s definition of “real estate professional” is much broader than the bright-line test of licensure. And although the qualifications to meet the standards are fairly rigorous, the resulting ability to re-characterize rental income as nonpassive rather than passive can mean substantial savings come tax time.
Section 469(c)(7)(B) requires that you meet two tests in order to qualify as a real estate professional for a taxable year:
- that more than one-half of the personal services you perform in all trades or businesses are performed in real property trades or businesses in which you materially participate; and
- that you worked more than 750 hours in real property trades or businesses in which you materially participate.
In other words, you must have spent more hours on real estate activities than non-real estate activities, and those real estate hours must have exceeded 750 hours on each real estate activity during the taxable year.
That last piece of the test, “each real estate activity” may seem daunting, except for the fact that you may choose to group all rental activities together in order to meet the 750-hour standard. This is called the “grouping election.”
The real-property trades or businesses that qualify, according to Section 469, are: development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. As you can see, the definition of real estate professional goes far beyond activities in which you must have a brokerage license in order to do business.
You may have noticed that the words “materially participate” were highlighted in the descriptions of the two tests above. That’s because there is a separate set of tests (seven in all, one of which you must pass) for determining whether you also meet the standard of material participation. For brevity’s sake, we’ll leave the details of those for another day.
So let’s say that the facts and circumstances of your business activities qualify you as a real estate professional, and also support the position that you materially participate in the rental activities that generate the income you’d like to re-characterize as nonpassive income, thus removing that income from the reach of the 3.8% surtax. You should be good to go, right?
Well, not so fast. According to just-finalized regulations, there is a third test that must be met, and that is that the rental income must have been earned in the “ordinary course of a trade or business.” In order to meet this particular standard, the taxpayer needs to prove that his involvement in the rental activities is “regular, continuous and substantial.” Huh?
The definitions involved in this particular test and the process the taxpayer must go through to make his case here are complicated and have been the subject of broad criticism by tax professionals during the drafting of this new regulation.
After much haggling, the government issued the final version which included a safe harbor qualifier to this new rule. The standard now holds that if the taxpayer participates in the rental real estate activity for more than 500 hours per year, then the rental income generated will qualify as being derived in the ordinary course of a trade or business.
The nice part is that the grouping election option for test #2 also applies to test #3 – in other words, if you chose to combine all your rental real estate activities into one economic unit for the purpose of meeting the 750-hour test, that same election will be recognized for the purpose of the 500-hour test.
Even though current regulations provide that one can use “any reasonable means to prove participation in an activity” and that “contemporaneous daily time reports, logs or similar documents are not required if the extent of such participation may be established by other reasonable means,” the burden of proof is squarely on the taxpayer, and it is not a slam-dunk.
However, the 3.8% surtax now presents a powerful economic motivation for many to wade into the process of qualifying as a real estate professional in the eyes of the IRS. As always, it will pay to have a conversation with your tax advisor to determine the best way forward in your particular case.
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