The health care reform legislation enacted in 2010 significantly broadens the Medicare tax base for higher-income taxpayers by enacting two new taxes. Beginning in 2013 higher-income taxpayers will be subject to an additional 0.9% tax on earned income and a new 3.8% tax on investment income. As a result, business income from an activity that is passive is now subject to the 3.8% tax as it is now considered investment income.
I. Planning for those taxpayers that have net passive income from rental activities:
Two areas of the tax law that provide planning opportunities are as follows:
1. Self-rental regulations
2. Status as a real estate professional
1. When looking at the self-rental regulations, if one or more activities are treated as a single activity, then they can be constitute an appropriate economic unit for the measurement of gain or loss under IRC Sec. 469 [Reg. 1.469-4(c)(1). This provides that rental and trade or business activities can be combined and considered an appropriate economic-unit, if it meets the following two tests:
(a) one activity is insubstantial in relation to the other, or
(b) each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.
Although no definition of insubstantial is provided in the regulations, under prior Temp. Reg. 1.469-4T, an 80/20 rule applied to determine if an activity was insubstantial. According to this rule, a rental activity could be combined with a trade or business activity if either the rental activity provided less than 20% of the gross income for the combined operation or vice versa.
A facts and circumstances test may also be used to identify activities constituting an appropriate economic unit for the measurement of gain or loss. Any reasonable method may be used to apply the relevant facts and circumstances. The most important factors are [Reg. 1.469-4(c)(2)]:
a. Similarities and differences in types of business.
b. The extent of common control.
c. The extent of common ownership.
d. Geographical location.
e. Interdependencies between the activities.
2. The second concept which should be considered when planning for 2013 relate to the ability of a taxpayer to qualify as a real estate professional. Here the taxpayer must meet two criteria:
1. Qualify as a real estate professional.
2. Materially participate in the real estate rental activity.
A taxpayer qualifies for the special relief provision for real estate professionals in any tax year if
(a) more than 50% of personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which he or she materially participates, and
(b) the taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which he or she materially participates. Regulations provide seven tests for determining material participation.
The material participation standard plays a role in two distinct aspects of the real estate professional rules. First, when determining whether a taxpayer qualifies as a real estate professional, only real property trades or businesses in which he or she materially participates are counted. Second, once it is determined that a taxpayer qualifies as a real estate professional, non-passive treatment is available only for rental real estate activities in which he or she materially participates.
II. Summary and Final Thoughts:
The health care reform legislation has created some excellent planning opportunities for higher-income taxpayers. Adequate planning with respect to the self-rental regulations and classification as a real estate professional are two instances where the taxpayer can eliminate the new 3.8% tax on passive income by converting those activities into non-passive.
Furthermore, upon the disposition of the activity, the gain would also not be subject to the additional tax.
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