IRS Offers Real Estate Professionals Safe Harbor on 3.8% NII Tax– January 15, 2014 by Mike McGivney

As a follow-up to our December 23rd post on the final IRC § 1411 regulations, the 3.8% Net Investment Income (NII) tax also has a significant impact on those individuals who are real estate professionals for tax purposes under IRC § 469. The final regulations outline a safe harbor position that these individuals can take to potentially avoid this tax.

What We Knew Before

The 3.8% NII tax is imposed on net passive income when a taxpayer’s modified adjusted gross income (AGI) exceeds $250,000 for joint filers, $200,000 for individuals or $125,000 for married filing separately. Among other items of income, NII includes rental income that was not earned in the ordinary course of a trade or business. When IRC § 1411 was first passed, those taxpayers who met the requirements of being a real estate professional and had elected to group their activities to meet the material participation tests initially thought the tax would not be assessed on their rental income, since such an election allows a taxpayer to treat such income and loss as nonpassive for regular income tax purposes. However, when proposed regulations were issued on IRC § 1411, that thought process changed.

The proposed regulations added an additional requirement to have rental income excluded from NII –such income would have to be from the “ordinary course of a trade or business.” How does the tax code define this? Quite simply, it doesn’t. As a result, taxpayers would need to assess each real estate activity separately (despite any grouping elections) to determine if it met the ordinary course of a trade or business threshold. Taxpayers seeking to exclude rental income from their calculation of NII would need to take a position based solely on facts and circumstances that such income was not taxable as NII.

What We Know Now

Fortunately, the final regulations provide real estate professionals with the opportunity for a safe harbor to avoid the NII tax. If a real estate professional participated in a rental real estate activity or group of activities for either more than 500 hours per year or more than 500 hours in five of the last 10 years, any income from such rental activity or activities will be deemed to be from the ordinary course of a trade or business, thus allowing a taxpayer to avoid the additional NII tax on the income. It is important to note that while the requirements of being a real estate professional can be met through involvement in a broad range of real estate activities, only involvement in rental activities counts towards the 500-hour hurdle.

It’s also important to note that if the safe harbor test is not met, relief from the NII tax may be available by establishing that the real estate income is from the ordinary course of a trade or business. Unfortunately, the IRS has not defined this concept, nor do we expect them to in the near future.

By instituting the safe harbor, the IRS has removed a significant amount of uncertainty for real estate professionals regarding the NII tax. As always, care should be taken to document hours spent on real estate activities should the IRS ever challenge your status as a real estate professional or the applicability of this tax.

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This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.