Real Estate advisor July • August 2013 Will you be on the hook? Tackling the new Medicare tax and rental activities Seller financing: It may or may not be a good idea Tax Court rules for taxpayer in self-rental rule case Ask the Advisor How can I give real estate to a charity? www.elliottdavis.com Will you be on the hook? Tackling the new Medicare tax and rental activities y now, you’ve heard about the new 3.8% NIIT will be applied to net investment income net investment income tax (NIIT), also to the extent that modified adjusted gross Bknown as the Medicare contribution tax. income (MAGI) exceeds the following thresh- It was created by the Health Care and Education olds: $250,000 for joint filers; $125,000 for Reconciliation Act of 2010 and took effect at the married taxpayers filing separately; and $200,000 beginning of 2013. The onset of the NIIT gives for single individuals and heads of households. some taxpayers with rental income yet another Individuals who are exempt from Medicare reason to seek status as a “real estate professional.” taxes may nonetheless be subject to the NIIT if they have both net investment income and Summing up the new tax MAGI above the applicable thresholds. Beginning this year, higher-income taxpayers gen- erally will be subject to the 3.8% NIIT on some Net investment income is calculated by deducting or all of their unearned income, including income from investment income certain expenses that can from some real estate activities and transactions. be allocated to that income. Investment income This is in addition to — and calculated separately includes (but isn’t limited to): from — the taxpayers’ regular income tax or alternative minimum tax (AMT) liability. n Interest, n Dividends, n Capital gains, n Rental and royalty income, n Nonqualified annuities (including payments under life insurance contracts), n Income from businesses involved in the trading of financial instruments or commodities, and n Income from businesses that are passive activities to the taxpayer (meaning the taxpayer doesn’t “materially participate” in the business). Such income is excluded from net investment income if it’s derived in the ordinary course of a trade or business that isn’t considered to be a passive activity with respect to you. Following the rules “Passive activity” is defined as any trade or busi- ness in which the taxpayer doesn’t materially participate. Rental real estate activities are usually 2 acquire, convert, rent, operate, manage or broker Aggregation to the rescue real property. Taxpayers who own multiple rental properties may What counts as material participation? According find it difficult to satisfy the material participation to the IRC, you materially participated in a rental requirement for each property. Fortunately, the activity if you satisfy one of the following tests: IRC allows you to establish material participation by electing to aggregate all rental properties as a n You participated in the activity for more than single rental activity. The election will be binding 500 hours during the tax year. for all future tax years in the absence of a mate- rial change in facts and circumstances. n Your participation for the tax year constitutes substantially all of the participation in such Note that the Treasury Department and the IRS activity of all individuals for the year. have determined that taxpayers should be given the opportunity to regroup in light of the net invest- n You participated in the activity for more than ment income tax. Thus, proposed regulations for 100 hours during the tax year, and at least as the new tax provide that taxpayers may regroup much as any other individual who participated their activities in the first taxable year beginning in the activity for the year. after Dec. 31, 2012, in which the taxpayer meets n The activity is a significant participation activity, the applicable income threshold and has net and you participated in such activities for more investment income. than 500 hours. (A significant participation activity is any trade or business activity in which considered passive activities regardless of whether you participated for more than 100 hours dur- you materially participate. ing the year and in which you didn’t satisfy any of the five other tests.) But the Internal Revenue Code (IRC) recognizes an exception from restrictions on passive activity n You materially participated in the activity for losses for taxpayers who are real estate profession- five of the 10 immediately preceding tax years. als. If you qualify as a real estate professional and materially participate, your rental activities are n Based on all the facts and circumstances, you treated as a trade or business, and you can offset participated in the activity on a regular, con- nonpassive income with your rental losses. You tinuous and substantial basis during the year. may also be able to enjoy the added benefit of avoiding the NIIT as long as you’re engaged in You can satisfy the test by electing to aggregate a trade or business with respect to the rental real your rental activities, often a necessary step. (See estate activities (that is, the rental activity isn’t “Aggregation to the rescue” above.) incidental to a nonrental trade or business). Can you prove it? You can qualify as a real estate professional by Under federal tax regulations, you can establish satisfying two requirements: 1) More than 50% of the extent of your participation in an activity “by the personal services you performed in trades or any reasonable means.” Reasonable means include businesses are performed in real property trades the identification of services performed over a or businesses in which you materially participate, period of time and the approximate number and 2) you perform more than 750 hours of of hours spent performing those services in the services per year in real property trades or busi- period, based on appointment books, calendars nesses in which you materially participate. “Real or narrative summaries. While contemporaneous property trades or businesses” include those that records aren’t required, having them will most develop or redevelop, construct or reconstruct, likely help you withstand IRS scrutiny. n 3 Seller financing: It may or may not be a good idea fter many long years, it appears that the commercial real estate market could be A making a comeback. That’s good news for many owners and investors, but it might be bad news if they can’t come up with the financ- ing they need to seal the deal. Fortunately, a handy tool known as seller financing might be just what the doctor ordered. Understand how it works In seller-financed transactions, the seller generally gives the buyer a secured loan to finance part of it’s qualified to become a lender. It should scruti- the property’s purchase price. A seller-financed nize its organizing documents, any joint venture, mortgage loan is secured by a lien on the prop- fund or upper-tier debt agreements, and applicable erty; a seller-financed mezzanine loan is secured regulatory requirements to determine if it’s allowed by a pledge of ownership interests in the pur- to make and hold loans. The seller may need to chasing entity. amend some documents to make it eligible to lend. Sellers might use this type of arrangement to The seller must comply with all applicable lending obtain cash to pay for operations or debt, or to laws, including those related to state licensing, debt satisfy investor redemption requests. Or, a seller collection and securities. The seller should also might choose seller financing to raise capital for assess whether it possesses the needed capabilities other business ventures or to generate liquidity to originate and service loans. And the seller must for the overall portfolio. determine if the property is appropriate for this type of arrangement. A financially robust prop- erty will produce optimal results for buyer, seller It’s critical that any current loan on and any third-party lender; conversely, a property a property grant the seller the right with many vacancies may not generate the returns needed to allow the buyer to pay off its obligations to prepay without incurring a penalty. to the seller and lender, let alone reap a profit. It’s critical that any current loan on the property Seller financing has additional advantages: It grant the seller the right to prepay without incur- can expand the pool of qualified buyers, foster ring a penalty. And the cash proceeds from the sale greater flexibility when negotiating loan terms, should be adequate to pay off the existing loan. and increase the chances of producing an out- come that meets both parties’ needs. Transactions involving third-party lenders will likely place the seller in the position of a subor- Don’t enter a transaction lightly dinate lender. But a seller in these circumstances Sellers must be cautious when entering into such might be able to command a higher interest rate transactions. Initially, the seller must ensure that because of its increased risk. 4 Finally, once a buyer is found, the seller must circumstances, a seller might be required to pay conduct thorough due diligence to confirm interest on the deferred capital gains tax liability that the buyer is creditworthy. The seller will typically enjoyed under the IRC’s installment need to scrutinize the buyer’s financial state- sale provisions. ments, credit history, tax returns and similar records. It’s also a good idea to request banking Be ready, but careful and business references. As the United States starts digging out from under a rather dismal commercial real estate market, you Be aware of the tax implications might want to jump quickly on any seller financ- Seller-financed transactions have some poten- ing available.