The Medicare Investment Tax, found in the Patient Protection and Affordable Care Act, went into effect this year and will have to be accounted for on some investors’ returns next year.
The tax is expected to raise $210 billion over 10 years. That amount has been reported as representing more than half of the new total expenditures in the health-reform package, according to the National Association of Realtors. The tax can be applied to residential and commercial real estate investments.
However, the association said it’s not a transfer tax on real estate sales. It also reported that the investment tax does not eliminate the benefits of the $250,000/$500,000 exclusion on the sale of a principal residence. But because interpreting the tax can be a tricky thing to do, the NAR told realtors to be familiar with it but not to advise clients on how to apply it to their returns.
The 3.8 percent tax is levied on investors with adjusted gross incomes of $200,000 for an individual and $250,000 for a joint return, or $125,000 for married persons who file separately. The types of income the tax can be applied to are interest, dividends, annuities, royalties, net rents and capital gains, minus any applicable deductions for any of those income sources.
“It’s also on any gains from the sale of property, other than property that is held in a trade or business in which the taxpayer materially participates, and on income from passive activities. So the bottom line of that is all dependent on the taxpayer’s participation,” said Nicholas Reister, an attorney who practices business, real estate, trust and estate law, and does probate litigation at Smith Haughey Rice & Roegge in Grand Rapids.
As Reister pointed out, the word “participation” is the key.
“What that tells us is the more we participate, the more likely we are to avoid the tax. I think what the federal government is trying to do is to encourage folks to be active, and discourage what I think is typically someone who buys properties and then just rents them out and is happy with the income that rolls in the door once they’ve made the investments through their triple-net leases, which pushes all the risks on the renter,” he said.
“What this does is it gives investors motivation to participate in the management of the property, and I think that somewhat discourages the investment in real estate,” he added.
That discouragement is likely to be especially true for “silent” investors who are simply looking for a place to park their money where it can grow while they go on with their daily lives.
“I think this acts as a discouraging factor for them,” he said.
“Keep in mind that it’s only 3.8 percent. But still, if you put that into $1 million worth of investment income, it’s $38,000 that gets wiped off the top.”
Because of the income thresholds, the investment tax doesn’t apply to everyone. For example, the retired couple under the threshold who own and lease the house next door won’t be affected by it. But someone who leases multiple homes or spaces in multiple commercial buildings might want to look into whether the tax might apply.
“I don’t think there is a magic or silver bullet here. Actively manage it and don’t just sit back and be inclined to take the profit because if you do, then the 3.8 percent comes off,” he said.
“Because it is a complicated tax, I think that makes knowing how to avoid triggering it somewhat difficult for the average layperson who has owned a few rental properties.”
There are numerous ways for someone to become active in a property, and on two fronts. One is to increase an investor’s economic risk, and that can be done by not going with triple-net leases, paying the real property tax, and picking up the maintenance, janitorial or utility costs.
Then, an investor can become personally involved in managing a property. There are various ways to do that, too. Collecting the rent checks is one way of getting involved. Performing inspections is another. Even snowplowing and shoveling the sidewalks qualifies.
“The more that someone participates, the more likely they are to avoid paying the 3.8 percent tax,” he said.
But having owners become more involved in the daily operations of their properties might not be music to the ears of the property managers who are in the business of doing those duties for a fee. For investors who employ such a company to do those tasks, Reister suggested they should do a cost-benefit analysis to determine whether it would be less costly to pay the tax or vice versa.
“You’ll have folks who will look at the 3.8 percent and say the value that a property management firm provides is above and beyond the 3.8 percent tax. It’s worth taking the 3.8 percent hit if the value is above and beyond that,” he said.
Real estate professionals, though, can relax: They’re exempt from the tax because the services they perform aren’t those of a passive investor. To qualify for the exemption, Reister said more than half of a professional’s services over the course of a year must be performed in a real property trade or business, and someone must perform more than 750 hours of services during the year in real property trades or businesses.
“I think what you have to keep in mind is that the tax is 3.8 percent. We pay more than that in sales tax,” said Reister. “So you have to ask yourself is the total potential tax bill worth what you’re going to have to do to avoid it?”