Author: R. Darden Bell, III, CPA
By now, most taxpayers have heard about the new .9% additional Medicare tax on earned income and the new 3.8% Medicare surtax on net investment income imposed by the new health care laws. The .9% Medicare tax is imposed on taxpayers receiving wages in excess of $200,000 (single) or $250,000 (married filing jointly) as well as 100% of net earnings from self- employment. The 3.8% surtax is imposed on the lesser of net investment income or the excess of modified adjusted gross income over the threshold amount. For more information on the 3.8% Medicare surtax, see The Basics of the 3.8% Surtax on Net Investment Income. Depending on the organizational structure of a rental activity, rental income could be subject to either of the taxes explained above. Effective tax planning can help a taxpayer avoid paying both taxes by setting up a rental arrangement that shifts income from a self- employment activity to a self-rental activity. A self- rental activity arises when a taxpayer owns and leases a building to another business entity the taxpayer also owns and operates.
In general, rents received are defined as passive income, which would be subject to the 3.8% surtax. However, rents received from a self-rental arrangement are automatically reclassified as active income. The IRS imposed this rule years ago to prevent taxpayers from artificially creating passive income to absorb or offset passive losses. Because rents from self-rental arrangements are automatically reclassified as active, they will not be subject to the 3.8% Medicare surtax. Due to the “rentals exception” described below, the rents from a self-rental arrangement could also avoid self-employment tax and the .9% additional Medicare tax on earned income. The IRS Regulations clearly explain that the .9% additional Medicare tax applies to only wages and self-employment income, not other activities to which the taxpayer is active. For more information on passive vs. active activities, see A Quick Snapshot of the Rental Real Estate Rules.
Rent from real estate and from personal property leased together with the real estate is one of the items specifically excluded when determining net earnings from self-employment. This “rentals exception” does not apply to:
- Rents received in the course of a trade or business as a real estate dealer;
- Rents from real estate paid in crop shares if certain conditions are met; and
- Payments made for rooms or other space where services (e.g. maid service) are also rendered to and primarily for the occupant’s convenience.
Services that can be provided to tenants without turning rental income into self-employment income include the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash.
If a taxpayer is receiving self-employment income from a partnership or a business that is reported on Schedule C of their personal return, and they also own a separate rental property, they can avoid paying self- employment tax on the rental property income by leasing the rental property to their closely-held business. If the taxpayer is already leasing their own building in a self-rental arrangement, they should consider increasing the rents paid to the rental entity. This will provide more deductions for the self- employment business while increasing income in the rental entity that is not subject to self-employment tax or any of the new surtaxes. This strategy should only be employed when a taxpayer is already paying self- employment tax. There would be little point to this strategy if the taxpayer’s active operating business is taxed as an S Corporation or C Corporation since self- employment tax does not apply to those entity types. Just make sure you don’t provide any convenience services that could cause the income to be considered self-employment income.
Should you have any questions related to this topic, feel free to contact your Keiter professional or Darden Bell for further clarification.
Disclaimer: The IRS is currently looking into the aspect of reclassifying self-rental income from passive to active as it relates to the NIIT. The issue is whether or not the rental activity rises to the level of a true trade or business under IRS Code Section 162. It appears that if the rental activity does meet the definition of a trade or business under IRC 162, the reclassification from passive to active may stand. However, if the activity doesn’t rise to the level of a trade or business, the rents will be considered passive income, even if they result from a self-rental activity. Keiter is actively monitoring the progress on this situation. We expect to receive clarification on this issue when the final regulations are issued sometime this fall.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.