Joseph P. Bartol
From real estate lifers to deep-pocketed retirees, many people decide at one time or another to invest in rental properties to produce a revenue stream. These investors should be aware of the Net Investment Income Tax (NIIT) that may reduce the profit potential for rental properties. The impact of the NIIT on rental real estate operations has been the source of some confusion since its adoption in 2013, leading to the issuance of final regulations on the topic in 2014.
The NIIT is a surtax of 3.8% of all “net investment income.” This surtax is in addition to the regular income tax, but it affects only single taxpayers with modified adjusted gross income over $200,000 and married taxpayers with a modified adjusted gross income over $250,000. Modified adjusted gross income is the same as your adjusted gross income plus certain deductions, such as student loan deductions or IRA contribution deductions.
Net investment income is defined by using three buckets. The first bucket includes your basic investment income from interest, dividends, annuities, royalties, and rental income. The second bucket is passive investment in a trade or business, meaning one in which the taxpayer does not materially participate. The third bucket is net gain attributable to the disposition of property, such as the sale of real estate. This article addresses when rental income within the first bucket may be subject to NIIT.
The policy behind NIIT is to collect tax from income that taxpayers receive without significant effort, that is, passive activity. Rental income is presumed to be derived from a passive activity and thus subject to NIIT. An exception exists, however, for rental income earned in the ordinary course of a real estate trade or business in which the taxpayer actively participates. This begs the question: “What is a business and what activities rise to the level of an active, non-passive operation?” Originally, one needed to look to a variety of subjective factors created by Internal Revenue Code §162 (trade or business expenses), §183 (passive activity losses), §469 (hobby losses), related regulations, and case law interpretation to answer this question. In the final regulations administering the NIIT, the IRS created a safe harbor to avoid the ambiguity of these subjective tests.
The NIIT safe harbor generally establishes thresholds for the point at which rental real estate activities rise to the level of active participation in a trade or business such that rental income produced from such activities is exempt from NIIT. While the regulations are rather complex, they establish a “yes” or “no” path to determine whether income from rental real estate activities is subject to NIIT. This path provides some clarity to taxpayers, allowing them to better assess the investment potential of a rental property.
If your modified adjusted gross income exceeds the thresholds ($200,000/$250,000) and your participation in your rental real estate activities is significant in comparison to your other business pursuits, we suggest you contact your lawyer or tax adviser to see if you may fit within the NIIT safe harbor. Doing so could save you from paying the 3.8% surtax on your rental income. Please feel free to contact us for more details on the NIIT regulations and safe harbor determination.
If you have any questions about how the information in this article may affect you or your business, please contact Joe Bartol at firstname.lastname@example.org or (608) 257‑2281 or your Stroud attorney.
DISCLAIMER: The information in this article is provided for general informational purposes only, is not necessarily updated to account for changes in the law, and should not be considered tax or legal advice. This article is not intended to create, nor does the receipt of it constitute, an attorney-client relationship. You should consult with your own legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.