Tax Pitfalls Facing Real Estate Investors

Beware of special tax law limits

For years, the passive activity loss (PAL) rules have plagued real estate investors who prefer to sit on the sidelines. But now, another tax wrinkle, the 3.8% Medicare surtax, may force you to re-examine your ways.

Background: Generally, losses from passive activities can only offset income earned from other passive activities. For this purpose, a passive activity is any undertaking that involves the conduct of a trade or business in which you do not materially participate. This requires participation in the business activity on a regular, continuous and substantial basis. The IRS has issued regulations detailing the requirements for attaining this status. As an example, you are considered to be a material participant if you work more than 500 hours a year at the activity.

A rental real estate activity is automatically treated as a passive activity. However, under a special tax law provision, an “active participant” in rental real estate may be able to use up to $25,000 of loss to offset nonpassive income. This exception is phased out for investors with an annual adjusted gross income (AGI) between $100,000 and $150,000. The tax benefit disappears completely if your AGI reaches $150,000.

Note that the active participation test is more stringent than the material participation test. The participation must be in a significant and bona fide sense. For instance, you might make management decisions, approve new tenants, arrange for repairs and so on. But simply listing yourself as a real estate manager or rental agent is not enough.

Now comes yet another tax consideration for real estate investors. Effective for 2013 and thereafter, the 3.8% Medicare surtax applies to the lesser of net investment income (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and a MAGI of $250,000 for joint filers. The definition of NII covers many income items such as capital gains, dividends, interest and the like. Significantly, NII also includes income from a passive activity. But there are several key exceptions, such as income from an active trade or business, as well as distributions from qualified retirement plans and IRAs (although these generally will increase your MAGI in the calculation).

Therefore, it can make an even bigger tax difference if you are characterized as a passive investor in real estate as opposed to an active investor.

One possible way to avoid an adverse tax outcome is to increase your level of participation to qualify as a real estate professional. Typically, to satisfy this test, you have to spend more than 750 hours on the activity during the year. Depending on your personal circumstances, it may be well worth the extra effort, when appropriate.

Analyze your situation with the assistance of your tax advisers. They can help you chart a course of action.