The regrouping of activities for real estate professionals under the 3.8% Net Investment Income Tax

For tax years beginning after December 31, 2012 a 3.8 % medicare tax is imposed on the lesser of an individual's net investment income, or modified adjusted gross income in excess of $200,000 ($250,000 in the case of a jointly filed income tax return). Net investment income is generally defined as income from interest, dividends, annuities, rents and royalties, as well as trade or business income from a passive activity. In addition to the ordinary income derived from the aforementioned sources the Net Investment Income Tax (NIIT) also applies to the gains derived from the disposition of the underlying assets, and to the disposition of interests in partnerships, and S corporations if the activities conducted constitute a passive activity. Income from rents is generally considered a passive activity subject to the above referenced additional tax, unless the real estate professional rules of IRC Sec. 469(c) (7) apply and the taxpayer materially participates in which case, the income is re-characterized as non passive income. However the statute generally provides that each rental real estate activity/property is treated as a separate activity therefore it could be difficult, to meet the definition of material participation in any one rental real estate activity. There is however another provision which permits an election to aggregate all of the professional's interests in rental real estate as one activity, whereby one would likely meet the material participation tests. As a general rule, this aggregation election is made at the time the taxpayer becomes a real estate professional, and is irrevocable once made. In addition to the requirements of IRC Sec. 469(c ) (7) which remove the per se passive characterization, the activity must also be a "trade or business" within the meaning of IRC Sect 162 in order to avoid the NIIT. If the activities are not a Sect 162 trade or business such as net leased property then the NIIT will apply in spite of the taxpayer's qualification as a real estate professional. Neither the proposed nor final regulations contain a clear bright line definition of what activities constitute a trade or business. The aggregation of activities for the real estate professional does not necessarily mean that the activity will qualify as a trade or business for NIIT purposes. Basic to the determination of passive activities, taxpayers have to group investments to determine their level of participation in the activity consisting of the grouped investments. Once these groups were decided they cannot be changed. The IRS has determined that the advent of the NIIT is a material change in facts and circumstances which permits a regrouping election. Thus there is a new opportunity to revisit the effects of a prior grouping election for the first year the taxpayer becomes subject to the NIIT. In conclusion, a careful analysis of the taxpayer's present grouping election should be conducted in order to maximize the tax benefits of grouping under the NIIT. Sandy Klein, CPA, is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.