Beginning Jan. 1, a taxpayer with net investment income — which generally includes rents, interest, dividends, annuities, royalties and gains from the sale of most stock, will be subject to an additional 3.8 percent tax on the lesser of net investment income, or adjusted gross income in excess of the applicable threshold ($250,000 for married filing jointly, $125,000 for married filing separately and $200,000 for all other taxpayers).
In my first installment, I addressed several steps that can be taken prior to year-end to reduce your future exposure to the new tax. Today, I take a look at two planning opportunities that kick in when the calendar turns to 2013.
Meet the material participation test for your S corporation or partnership. If you own an interest in an S corporation or partnership, the tax law requires you to determine whether you are a passive or non-passive investor. In simple terms, you are treated as a passive investor unless you meet one of seven “material participation” tests, the most common of which is satisfied if you participate in the activity for more than 500 hours during the year.
The motivations for qualifying as a non-passive investor are twofold. First, only a non-passive investor can utilize losses from the business without limitation; passive investors can only use losses to offset other passive income. Starting in 2013, however, even taxpayers with income from an S corporation or partnership will have a vested interest in qualifying as a non-passive investor, because the additional 3.8 percent tax will not apply to income earned from a non-passive investment, but will apply to income earned by a passive investor. As a result, pumping a few extra hours into your S corporation or partnership during 2013 could save you 3.8 percent in tax on the resulting income.
Example: Danny Noonan, a single taxpayer, is employed full-time as a caddy at the Roaring Fork Club, where he draws a $200,000 annual salary. On the side, Danny also owns 50 percent of an S corporation that serves burritos outside of Eric’s from 12-4 a.m. every Friday and Saturday night. The stand is quite profitable, generating $50,000 of income to Danny every year. During 2012, Danny spent 450 hours serving burritos.
In 2013, there is tremendous motivation for Danny to work an extra 50 hours at the burrito stand. If he works in the S corporation for 500 hours, Danny would pass the material participation test and be treated as a non-passive investor. As a result, the $50,000 of income allocated to Danny from the S corporation would not be considered net investment income, and he would save $1,900 in additional tax.
Satisfy the real estate professional test. Aspen has more than its fair share of landlords, and each one may want to pay particular attention to the next few paragraphs.
In general, net rental income is subject to the 3.8 percent tax on investment income. The law provides an exception, however, for rental income that is not considered passive to the landlord. Unfortunately, as a default rule, all rental activities are treated as passive. This presents a bit of a conundrum: If all rental activities are passive, but only non-passive rental activities can avoid the additional 3.8 percent tax, what is a taxpayer to do?
Here’s the fix. The rental activities of certain “real estate professionals” are not considered passive. As a result, if you can meet the standards of a real estate professional, you will not be subject to the additional 3.8 percent tax on your net rental income.
In order to be treated as a real estate professional, you must satisfy two tests:
1. More than half of your hours worked throughout the year must be performed in “real estate activities” in which you materially participate.
2. You must work more than 750 hours during the year in real estate activities in which you materially participate. For purposes of these tests, material participation is measured in the same manner as discussed in the preceding planning opportunity; i.e., if you satisfy one of the seven tests provided by the tax law, you will be treated as having materially participated. Note that you also can elect to “group” certain activities together for purposes of meeting this standard.
“Real estate activities” extend beyond holding property as a landlord; they also encompass any work you may perform as a developer, broker, or builder. The purpose of these tests, however, is to ensure that only taxpayers who truly ply their trade in the real estate industry are able to take advantage of the favorable treatment afforded real estate professionals. Looking at things logically, if you work 2,000 hours as say, a chef, it will prove nearly impossible to satisfy the “more than half” test, because you would need to spend 2,001 hours working on your rental properties, which isn’t very likely.
If you do spend the majority of your time working it the real estate industry and can satisfy the real estate professional tests, however, you will avoid the 3.8 percent tax on your net rental income:
Example: Enrico Palazzo works 1,200 hours per year as an opera singer. He also owns two rental properties that produce significant income. In 2012, Enrico materially participates in each rental — spending 500 hours on each property — but does not meet the standards of a real estate professional because he has not worked more than half of his total hours in his real estate activities (1,200 versus 1,000).
In 2013, if Enrico can find the time to devote an extra 201 hours to his rental real estate — or if he can spend less time in his opera business — he will qualify as a real estate professional. As a result, the net rental income generated by the properties will not be subject to the additional 3.8 percent tax.
While the additional 3.8 percent tax on net investment income represents a painful addition to the tax law, as indicated above and in the previous column, with a little attention to detail, it can be managed. Happy Holidays, everyone.
Tony J. Nitti, CPA, MST, can be reached at email@example.com .