By Frederick R. Berk, CPA, partner, Friedman LLP
Do you consider yourself a real estate professional? The IRS may have a different definition – and it may be the difference between costing or saving you a significant amount of tax dollars.
In a new law that went into effect January 1, income from rental real estate activities and capital gains from the sale of real estate will generally be subject to an additional 3.8% tax referred to as the “Medicare Tax”, which was instituted to help fund “Obamacare”.
This tax applies to individuals with modified adjusted gross income in excess of $200,000 for single return filers and $250,000 for joint filers.
The effect is an increase in the top federal rate from 39.6% to 43.4%, resulting in the top tax rate increasing by 9.6% (3.8 ÷ 39.6) and a corresponding increase in the top capital gains rate.
There is good news for those who are deemed to be “Real Estate Professionals” and who materially participate in real estate activities: they will not be subject to the new Medicare Tax on their rental real estate income and will be able to deduct net losses from real estate against any other type of income.
The potential savings could be significant, as this exemption from the Medicare Tax also applies to gains from the sale of real estate.
There are two hurdles a taxpayer must clear to qualify to be exempt from the Medicare Tax: First, the Real Estate Professional test must be met.
If that test is met, then the material participation test must be met. Most people who can meet the Real Estate Professional test will also be able to meet the material participation test. However, meeting these two tests is not as straightforward as it would seem.
Most people who spend a significant amount of their time working in the real estate industry would instinctively classify themselves as Real Estate Professionals.
To actually meet the standard, though, and qualify to be exempt from the Medicare Tax, certain specific criteria must be met.
First, to be a Real Estate Professional, you must spend more than 750 hours during the year working in real estate trades or businesses and more than 50% of your time must be spent performing “personal services” relating to real estate trades or businesses.
However, time spent as an employee in a real estate company counts only if you own more than 5% of the company.
For example, a senior executive who spends 100% of their time working in a real estate company and invests in or has been given equity in real estate ventures will not qualify as a Real Estate Professional if he/she does not own more than 5% of the company.
The types of personal services performed as an employee which can be used to satisfy the Real Estate Professional test are real estate development (which would include builders and contractors), owning of rental properties, property management services and real estate brokerage activities.
However, as previously stated, these services only count if you own more than 5% of your employer.
After you’ve been classified as a Real Estate Professional, you must demonstrate that you “materially participate” in real estate activities.
There are various tests to determine if you meet the material participation rules, but these are beyond the scope of this article.
The objective of this article is to highlight the potential cost to employees who are unable to meet the Real Estate Professional Test because they lack the requisite 5% ownership interest.
As a result of the 5% ownership rule, it could be difficult for someone with a full-time job to meet the 750 hour test; it is significantly more difficult to meet the more than 50% test.
Upon examination, the Internal Revenue Service would ask to see the employment contract, if one exists. Most employment contracts stipulate that the employee devote substantially all of his/her business time, attention and energies to the performance of the business and affairs of the employer; therefore employees who do not have a greater than 5% ownership interest in their employer would have a difficult time proving they are a Real Estate Professional under the regulations.
With planning, ingenuity and flexibility, you may be able to qualify as a “Real Estate Professional” and reap the tax benefits. In any event, a qualified professional should be consulted.