How the Net Investment Income Tax affects real estate investors

The net investment income tax (NIIT) is a new tax created with the passage of the Patient Protection and Affordable Care Act, also known as Obamacare. The 3.8 percent tax on the net investment income of high-wage earners became effective for the tax year beginning Jan. 1, 2013.

Net investment income generally includes:

  • Category 1 – Interest, dividends, annuities, royalties and rents.
  • Category 2 – Income from passive activities and businesses involved in the trading of financial instruments.
  • Category 3 – Net gain from the disposition of property other than property held in a trade or business.

​Those subject to the tax are high-income earners, who are U.S. residents, have net investment income, and a modified adjusted gross income over the threshold of $250,000 for married people filing jointly, $125,000 for married people filing separately, or $200,000 for single people. For most taxpayers, modified adjusted gross income (MAGI) and adjusted gross income (AGI) will be the same. AGI is found on Line 37 of the Form 1040 tax return.

The tax is calculated at 3.8 percent times the lesser of the taxpayer’s:

  • Net investment income
  • MAGI less the applicable threshold

For real estate investors, rents are included under the first category of net investment income and the second category of passive income. The third category includes gains from the sale of real estate properties.

Active real estate professionals, however, have found safe harbor with recently released final regulations regarding the NIIT. If a real estate professional participated in rental real estate activities for more than 500 hours per year in five of the last 10 taxable years, the rental income is deemed to be derived in the ordinary course of business, thus removing it from the first two categories and excluding it from the NIIT. However, failure to meet the 500-hour test does not necessarily mean taxpayers cannot be considered real estate professionals. They may state facts and circumstances specific to their situation to prove their level of activity.

Taxpayers should discuss specifics with their CPA if they have questions and to see if they qualify as a real estate professional.

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