Tax Strategy Tuesday: Avoid Real Estate Net Investment Income Tax

real estate net investment income tax blog post artAre you a real estate investor? And, just to get the awkward part over, have you been pretty successful with real estate?

I thought that might be the case. Which brings me to the point of this blog post. You should explore whether you can avoid net investment income tax on your real estate rental income and gains.

The net investment income tax—you may think of it as the Obamacare tax or NIIT—runs roughly 3.8 percent on your real estate profits. So 3.8 percent of your net rental income. And 3.8 percent of your gains when you sell property.

And then the reason for bringing this strategy up now, at the very start of the year. If you are going to avoid net investment income tax? You want to adopt the tax strategy discussed here now. At the very start of a year. That works best. It works easiest.

Note: We’ve been posting a new tax strategy for high income taxpayers every Tuesday for several weeks now: See here for the complete list: Tax Strategy Tuesday.

The Avoid Real Estate Net Investment Income Tax Strategy in a Nutshell

You maybe already know this. But if a single individual’s modified adjusted gross income exceeds $200,000 or married taxpayers’ joint return shows modified adjusted gross income that exceeds $250,000? The taxpayer or taxpayers pay a 3.8 percent net investment income tax on some or all of their real estate profits.

Note: Modified adjusted gross income essentially equals adjusted gross income. In most cases.

Many real estate investors, however, can sidestep the net investment income tax. The U.S. Treasury’s regulations describe a handful of ways to do this. But the easiest and cleanest way? Qualify as a real estate professional who materially participates in your investment properties.

The rules for being a real estate professional work pretty simply, fortunately. The taxpayer (if single) or one spouse (if a married couple files a joint return) needs to meet a material participation threshold and then also needs to spend more than fifty percent of work time and more than 750 hours a on something real-estate-y. Like being the family’s property manager.

A variety of material participation rules work. But the IRS provides a safe harbor formula for these folks that suggests 500 hours a year of participation. (The safe harbor appears in Reg. Sec. 1.1411-4 paragraph (g)(7) near the end of the page.)

Possible Tax Savings from the Avoid Real Estate NIIT Strategy

The savings from avoiding net investment income tax on real estate? Substantial for high-income real estate investors.

Say a married couple earns $200,000 in non-real-estate income. Maybe the income comes from a job. Or from retirement benefits. Further, say the investor also earns another $400,000 in real estate profits. This money might be from rental income. It might be from selling a property for gain.

If the married couple can’t avoid NIIT, they pay the 3.8 percent tax on $350,000. (The tax applies to the lesser of their real estate income or the amount their modified adjusted gross income exceeds $250,000.) That means roughly a $13,000 annual NIIT tax bill.

If they qualify as a real estate professional and meet the material participation requirement, however, bingo. They avoid the roughly $13,000 tax.

Turbocharging the Avoid Real Estate NIIT Strategy

First, and sadly, we regularly see returns for taxpayers who paid NIIT even though they clearly qualified as real estate professionals and should not have paid NIIT. Probably this error stems from either someone self-preparing their return or someone working with a low-skilled preparer who didn’t know enough to handle NIIT. The good news if you happen to be in this situation? You should be able to amend the last two or three years of tax returns. (Discuss this as soon as you can with your accountant.)

A second comment: If there’s a year in which you know you’ll report a big profit from your real estate investing—perhaps a property sale—that’s the year to work hard to qualify as a real estate professional.

One other thing to mention someplace in this blog post: At least a couple of other techniques for avoiding real estate net investment income tax appear in the Treasury regulations. Self-rental situations should often let someone avoid NIIT on real estate income, for example. And real estate developers who rent a property they’ve developed also have an easy way to at least temporarily avoid NIIT on rental income.

And then the regulations hint at some other possibilities. Like short-term rentals. And loopholes for farmers and ranchers.

The bottom line here: If you can’t get the real estate professional designation to work, don’t give up. Ask your tax advisor if one of the other loopholes let you avoid paying NIIT.

Limits to Avoid Real Estate Net Investment Income Tax Strategy

You, or your spouse if you’re married, needs to not only qualify as a real estate professional. You also need to meet material participation thresholds. That means you can’t use this tax strategy to avoid NIIT on passive real estate investments. Sorry.

Further, as we write this, the status of the Build Back Better Act is unclear. But the version of the legislation circulating right now (which may differ from the version that passes) closes this loophole for real estate investors who enjoy a taxable income of more than $400,000 if single and more than $500,000 if married.

We discuss how this proposal works here: Build Back Better Hits S Corporations and Active Real Estate Investors. But in a nutshell, someone with a taxable income that exceeds $400,000 or $500,000 begins losing their ability to avoid NIIT on real estate income, and these folks completely lose the ability to avoid NIIT once taxable income rises to $500,000 or $600,000.

The Avoid NIIT Strategy Works Best for These Taxpayers

The avoid real estate net investment income tax strategy only practically works for taxpayers with direct real estate investments. (Only these folks can usually pass the material participation test.)

It also works most easily for situations where the taxpayer or a spouse qualifies as a real estate professional because they already work 750 hours a year or more in a real estate trade or business. So, for example, someone already self-employed as developer, redeveloper, construction contractor, rental agent, property manager, real estate broker or agent. Or someone who already owns five percent or more of a firm engaged in these activities.

Note: Tax law provides this definition of a real estate business. “…the term ‘real property trade or business’ means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Other Information Sources

The IRS’s treasury regulations for passive losses and net investment income tax should be read thoroughly and referenced by the tax accountants using this strategy.

The taxpayer who runs this strategy probably also wants to get a good grasp of the rules for real estate professionals and particularly the mechanics of counting real estate hours. A person might also want to peek at the earlier Tax Strategy Tuesday post on real estate professionals.

Finally, confirm with your tax advisor about whether this strategy even makes sense. You might not want to go to the work of being a real estate professional if the savings amount to only a few hundred dollars a year, for example. And then, as always, if you have not yet found a tax advisor, please consider becoming a client of our CPA firm.

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