Until this year, landlords who earned profits from their rentals didn’t have to worry about whether they qualified as a “real estate professional” for tax purposes. The only reason to seek to qualify as such was to avoid application of the incredibly complex passive loss rules.
These rules are designed to prevent landlords from deducting rental losses from their other non-rental income. So if you didn’t have rental losses, these rules didn’t concern you and you could care less whether or not you were a “real estate professional.”
This has now changed. Qualifying as a real estate professional will now benefit many landlords who earn profits from their rentals because, by doing so, they won’t have to pay the Net Investment Income tax (NII tax) on them.
The Net Investment Income tax, enacted to help fund Obamacare, took effect on Jan. 1, 2013. If you’re subject to it, you’ll have to pay it starting when you file your 2013 return next year.
The NII tax is a separate flat 3.8 percent income tax on unearned income, including rental income and gains from selling rental property. However, you’ll be subject to the NII tax only if your adjusted gross income for the year exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly ($125,000 for marrieds filing separately).
If your AGI exceeds the applicable threshold, you’ll have to pay the NII tax on the lesser of (1) your net investment income, or (2) the amount that the your AGI exceeds the $200,000/$250,000 threshold.
Example: Lucy, a single taxpayer, earns $200,000 in gross rents during 2013 and has $100,000 in expenses, ending up with $100,000 in net rental income that must be included in her AGI. She also has $250,000 in net active business income from her real estate brokerage business. Her AGI for 2013 is $350,000–$150,000 over the $200,000 NII tax threshold. She must pay the 3.8 percent NII tax on the lesser $150,000 or $100,000. Since $100,000 is less, she owes $3,800 in NII tax for the year that she must pay along with her regular income taxes.
Fortunately, people like Lucy may be able to avoid the NII tax. There is a special exemption for real estate professionals. You must satisfy three tests to be eligible for this exemption:
You must be a real estate professional
You must materially participate in the rental activity, and
Your rental activity must qualify as a business for tax purposes.
The key to proving it and avoiding the IRS’s wrath is keeping accurate records of how many hours you (and your spouse, if any) work at your real estate activities during the year.
Definition of a ‘real estate professional’
The rules for qualifying as a real estate professional for NII tax purposes are the same as those under the dreaded passive loss rules. To qualify, you (or your spouse if you file jointly) must spend (1) more than 50 percent of your work time in a real estate business or businesses, and (2) more than 750 hours working in real estate businesses during the year. As a rule, people with full-time jobs outside of real estate cannot qualify.
‘Material participation’ in rental activity
In addition to being a real estate professional, you must materially participate in each rental activity to qualify for this exemption.
There are various methods to establish material participation. The two most common are working over 500 hours at the activity during the year, or working 100 hours and more than anyone else.
If you have more than one rental property, unless you group your rentals together for these purposes, you’ll have to materially participate in each individual rental. For example, if you have 10 rentals, you’d have to materially participate for each of the 10, which would likely prove impossible.
Fortunately, you are allowed to group your rental activities together for these purposes. This way, you can combine the time you spend working on each rental property to satisfy the material participation tests. You must file an election with the IRS to group your rental activities.
Ordinarily, you are only allowed to group your activities one time, and are then stuck with it. However, the IRS has decided to give real estate professionals who have previous grouped their activities a “fresh start.” They are permitted to redo their groupings starting in 2014.
Rental activity as a business
Finally, your rental activity must qualify as a business for tax purposes. The IRS has never clearly defined when a rental activity qualifies as a business rather than an investment. However, most real estate professionals’ rental activities likely qualify as businesses. One exception: landlords with triple net leases.
Example: Assume that Lucy from the above example owns a 15-unit apartment building she manages herself. She spends 100 percent of her time — more than 1,800 hours per year — working at her two real estate activities: brokerage and landlording. She spends 550 hours each year managing her rental, which is obviously a business. She qualifies for the real estate professional exemption and won’t have to pay the NII tax on her rental income.