Will You Be on the Hook? Tackling the New Medicare Tax and Rental Activities

ANITA WESCOTT, CPA

By now many of you have heard about the new 3.8% net investment income tax (NIIT), also known as the Medicare contribution tax.  It was created by the Health Care and Education Reconciliation Act of 2010 and took effect at the beginning of 2013.  The onset of the NIIT gives some taxpayers with rental income yet another reason to seek status as a “real estate professional.”

Summing Up the New Tax

Beginning this year, higher-income taxpayers generally will be subject to the 3.8% NIIT on some or all of their unearned income, including income from some real estate activities and transactions.  This is in addition to — and calculated separately from — the taxpayers’ regular income tax or alternative minimum tax (AMT) liability.

NIIT will be applied to the lesser of net investment income OR modified adjusted gross income (MAGI) in excess of the following thresholds:

• $250,000 for joint filers;
• $125,000 for married taxpayers filing separately; and
• $200,000 for single individuals and heads of households.

Individuals who are exempt from Medicare taxes may nonetheless be subject to the NIIT if they have both net investment income and MAGI above the applicable thresholds.

Net investment income is calculated by deducting from investment income certain expenses that can be allocated to that income.  Examples of potentially allocatable expenses include investment interest expense, brokerage fees, rent and royalty expenses, and state and local income taxes.

Investment income includes, but is not limited to:

• Interest;
• Dividends;
• Capital gains;
• Rental and royalty income;
• Nonqualified annuities (including payments under life insurance contracts);
• Income from businesses involved in the trading of financial instruments or commodities; and
• Income from businesses that are passive activities to the taxpayer (meaning the taxpayer doesn’t “materially participate” in the business).

Any income (except trading) is excluded from net investment income if it is derived in the ordinary course of a trade or business that is not considered to be a passive activity with respect to you.

Following the Rules

“Passive activity” is defined as any trade or business in which the taxpayer does not materially participate.  Rental real estate activities are usually considered passive activities regardless of whether you materially participate.

The Internal Revenue Code (IRC) recognizes an exception from restrictions on passive activity losses for taxpayers who are real estate professionals.  If you qualify as a real estate professional and materially participate, your rental activities are treated as nonpassive, and you can offset nonpassive income with your rental losses.  You may also be able to enjoy the added benefit of avoiding the NIIT as long as you are engaged in a trade or business with respect to the rental real estate activities (that is, the rental activity isn’t incidental to a non-rental trade or business).

You can qualify as a real estate professional by satisfying two requirements: 1) More than 50% of the personal services you performed in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services per year in real property trades or businesses in which you materially participate.  “Real property trades or businesses” include those that develop or redevelop, construct or reconstruct, acquire, convert, rent, operate, manage or broker real property.

What counts as material participation?  According to the IRC, you materially participated in a rental activity if you satisfy one of the following tests:

• You participated in the activity for more than 500 hours during the tax year.
• Your participation for the tax year constitutes substantially all of the participation in such activity of all individuals for the year.
• You participated in the activity for more than 100 hours during the tax year, and at least as much as any other individual who participated in the activity for the year.
• The activity is a significant participation activity, and you participated in such activities for more than 500 hours. (A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t satisfy any of the five other tests.)
• You materially participated in the activity for five of the 10 immediately preceding tax years.
• Based on all the facts and circumstances, you participated in the activity on a regular, continuous and substantial basis during the year.

You can satisfy the test by electing to aggregate your rental activities, often a necessary step.  (See the sidebar “Aggregation to the Rescue”).

Can You Prove It?

Under federal tax regulations, you can establish the extent of your participation in an activity “by any reasonable means.” Reasonable means include the identification of services performed over a period of time and the approximate number of hours spent performing those services in the period, based on appointment books, calendars or narrative summaries. While contemporaneous records aren’t required, having them will most likely help you withstand IRS scrutiny.

If you would like additional information or have questions, please contact Anita Wescott at [email protected] or call her at 312.670.7444.

Sidebar: Aggregation to the Rescue

Taxpayers who own multiple rental properties may find it difficult to satisfy the material participation requirement for each property. Fortunately, the IRC allows you to establish material participation by electing to aggregate all rental properties as a single rental activity.  The election will be binding for all future tax years in the absence of a material change in facts and circumstances.  There are both advantages and disadvantages to making the election so careful consideration should be given before electing to aggregate.

Note that the Treasury Department and the IRS have determined that taxpayers should be given the opportunity to regroup in light of the net investment income tax.  Thus, proposed regulations for the new tax provide that taxpayers may regroup their activities in the first taxable year beginning after Dec. 31, 2012, in which the taxpayer meets the applicable income threshold and has net investment income.

Seller Financing: It May or May Not be a Good Idea

The recovering commercial real estate market might be bad news for owners and investors who can’t come up with the financing they need to seal the deal. Since 2008, lenders have decreased their lending activity, in part as a result of the collapse in value of the commercial mortgage-backed securities and derivatives. Seller financing may be a solution to this lending issue. This article explains how seller-financed transactions work and notes the many issues to address, including tax implications.

After many long years, it appears that the commercial real estate market could be making a comeback. That’s good news for many owners and investors, but it might be bad news if they can’t come up with the financing they need to seal the deal. Fortunately, a handy tool known as seller financing might be just what the doctor ordered.

Understand How it Works

In seller-financed transactions, the seller generally gives the buyer a secured loan to finance part of the property’s purchase price. A seller-financed mortgage loan is secured by a lien on the property; a seller-financed mezzanine loan is secured by a pledge of ownership interests in the purchasing entity.

Sellers might use this type of arrangement to obtain cash to pay for operations or debt, or to satisfy investor redemption requests. Or, a seller might choose seller financing to raise capital for other business ventures or to generate liquidity for the overall portfolio.

Seller financing has additional advantages: It can expand the pool of qualified buyers, foster greater flexibility when negotiating loan terms, and increase the chances of producing an outcome that meets both parties’ needs.

Don’t Enter a Transaction Lightly

Sellers must be cautious when entering into such transactions. Initially, the seller must ensure that it’s qualified to become a lender. It should scrutinize its organizing documents, any joint venture, fund or upper-tier debt agreements, and applicable regulatory requirements to determine if it’s allowed to make and hold loans. The seller may need to amend some documents to make it eligible to lend.

The seller must comply with all applicable lending laws, including those related to state licensing, debt collection and securities. The seller should also assess whether it possesses the needed capabilities to originate and service loans. And the seller must determine if the property is appropriate for this type of arrangement. A financially robust property will produce optimal results for buyer, seller and any third-party lender; conversely, a property with many vacancies may not generate the returns needed to allow the buyer to pay off its obligations to the seller and lender, let alone reap a profit.

It’s critical that any current loan on the property grant the seller the right to prepay without incurring a penalty. And the cash proceeds from the sale should be adequate to pay off the existing loan.

Transactions involving third-party lenders will likely place the seller in the position of a subordinate lender. But a seller in these circumstances might be able to command a higher interest rate because of its increased risk.

Finally, once a buyer is found, the seller must conduct thorough due diligence to confirm that the buyer is creditworthy. The seller will need to scrutinize the buyer’s financial statements, credit history, tax returns and similar records. It’s also a good idea to request banking and business references.

Be Aware of the Tax Implications

Seller-financed transactions have some potentially vexing tax implications. If, for example, the seller is a real estate investment trust (REIT), it must determine whether the loan constitutes a “qualifying asset” that generates “qualifying income.” A seller-financed loan could jeopardize the seller’s status as a REIT under the Internal Revenue Code (IRC) if the loan isn’t properly structured.

The IRC’s original issue discount (OID) rules can also come into play if the loan’s redemption price exceeds its issue price. If OID does enter the picture, the seller must recognize interest income, and the buyer must recognize interest expense, based on economic accrual. Under certain circumstances, a seller might be required to pay interest on the deferred capital gains tax liability typically enjoyed under the IRC’s installment sale provisions.

Be Ready, But Careful

As we start to dig out from under a rather dismal commercial real estate market, you might want to jump quickly on any seller financing available. However, there are many issues you’ll need to address. To ensure the best results are achieved, you should consult with experienced real estate and financial advisors.

If you would like additional information or have questions, please contact Anna Coldwell at 312.670.7444.