Self-Rental Income Exempted From The New Medicare Tax
The IRS has backtracked on its guidance from 2012, by exempting certain self-rental income from the new 3.8% Medicare surtax. The new guidance applies common sense by aligning the tax treatment of self-rental arrangements with the passive loss rules under Section 469. Taxpayers should be able to avoid the surtax with a little pre-planning.
The Affordable Care Act includes a new 3.8% Medicare surtax on the unearned investment income of high-income individuals. The new surtax went into effect on Jan. 1, 2013, and applies to interest, dividends, capital gains, rental and royalty income, certain annuities, and income from certain passive trade or business activities. The Medicare surtax applies to persons with modified adjusted income over certain thresholds ($200,000 for head of household; $250,000 for married joint filers). In December 2012, the IRS issued preliminary regulatory guidance for applying the new surtax. Final regulations were issued in November 2013.
Many of our clients hold real estate under a self-rental structure – that is, the real estate is held in one entity and is leased out to a separate operating company, which operating company makes rental payments to the first entity. This structure is used for non-tax reasons, including financing and asset protection.
The preliminary regulations issued in 2012 had unexpected consequences for these types of self-rental arrangements. Income from self-rental arrangements has historically been treated as non-passive for other tax purposes but would have been captured by the new 3.8% surtax under the proposed regulations. Specifically, the Section 469 passive-activity regulations expressly treat self-rental income as non-passive (to prevent taxpayers from artificially creating passive losses). The preliminary regulations for the new surtax did not include a similar carve-out that treats self-rental arrangements as non-passive. So what had been expressly excluded from passive income taxation in the past would possibly have been subject to the new 3.8% tax. This would have been a big deal for many of our clients.
Luckily, the IRS applied common sense and added a carve-out for self-rental income in the final regulations. The final regulations issued in December 2013 provide that an arrangement that is treated as non-passive under the Section 469 passive loss self-rental rule will also be considered non-passive for the 3.8 percent Medicare surtax. The non-passive treatment also applies for a subsequent sale of the property. An overlapping alternative in the final regulations provides that if the rental real estate activity is grouped with an operating activity that qualifies as a trade or business, then the real estate activity will rise to the level of a trade or business activity and therefore, will not be subject to the 3.8 percent Medicare surtax.
Proper planning and structuring is necessary to take advantage of the new favorable final regulations. Given the potentially significant negative tax consequences, we urge our clients to take steps now to ensure their self-rental arrangements are structured appropriately so that they fall outside the scope of the new surtax.