Tax Tangles: Income Tax Watch List for Real Estate
This edition of The Real Deal inaugurates “Tax Tangles,” a new periodic feature by members of WTP’s Tax Section. In this inaugural article, Michael J. Grace, Counsel in our Washington, DC office, highlights two provisions of federal income tax law to which businesses and individuals in the real estate industry should pay particular attention: Like-Kind Exchanges and 3.8% Net Investment Income Tax. Future installments of Tax Tangles will address other “hot tax topics” for real estate including partnership profits interests and carried interests, depreciation and amortization, and tax basis in partnership liabilities.
Readers interested in learning more about the subjects this article highlights or other income tax issues affecting the real estate industry may contact Michael Grace at 202-659-6776 or firstname.lastname@example.org.
In general, a taxpayer recognizes no taxable gain or loss upon exchanging business or investment property for other “like-kind” business or investment property. For example, a taxpayer generally recognizes no gain or loss upon exchanging an appreciated office building for an apartment building. Tax basis in the relinquished property carries over to the replacement property. As a result, the exchanging taxpayer eventually will recognize the deferred gain from the relinquished property, but not until selling the replacement property.
Both Congress and the Obama Administration recently have targeted this traditionally powerful tax deferral technique. In a comprehensive Tax Reform Bill of 2014, Dave Camp, Chairman of the tax-writing House Ways and Means Committee, has proposed to eliminate like-kind exchanges. In its proposed US Budget for Fiscal year 2015, the Obama Administration has proposed limiting to $1 million (indexed for inflation) the amount of capital gain a like-kind exchange of real property could defer.
3.8% Net Investment Income Tax
Starting in 2013, individuals, estates, and trusts are subject to an additional federal tax on “Net Investment Income.” Affected taxpayers must pay this 3.8% tax on top of regular or alternative minimum tax on the same income.
Assume, for example, that an individual invests in dividend paying stocks. The investor may be subject to not only a maximum 20% regular or alternative minimum tax on the dividends but also an additional 3.8% tax for a total effective federal tax rate of 23.8%. Any applicable state or local income taxes would further increase the effective tax rate.
Individuals, estates, and trusts are subject to this tax if they have both (i) net investment income and (ii) modified adjusted gross income exceeding threshold amounts. For example, married taxpayers filing a joint income tax return may be subject to the 3.8% tax if their modified adjusted gross income exceeds $250,000. For unmarried individuals, the threshold amount is $200,000.
Net investment income broadly includes (i) interest, dividends, annuities, royalties, and rents not derived in the ordinary course of a trade or business, (ii) income from passive activities and businesses of trading in financial instruments or commodities, and (iii) net gain from disposing of property generating those categories of income. Passive activities for this purpose include (i) rental activities (subject to some exceptions) and (ii) non-rental trades or businesses in which the taxpayer does not materially participate.
For individuals in the real estate business, the 3.8% tax has inverted income tax planning typical since the Tax Reform Act of 1986. Before 2013, real estate entrepreneurs and investors tended to prefer passive income over nonpassive income because passive income can be sheltered by passive losses. Now, net passive income (unlike nonpassive income) may be subject to this additional 3.8% tax. As a result, real estate entrepreneurs and investors generally will want to avoid having passive income (assuming they have no offsetting passive activity losses).
Some qualifying real estate professionals can structure or restructure their operations to avoid or at least mitigate the sting of the net investment income tax. Qualifying taxpayers basically consist of individuals who during the year work more than 750 hours and put more than 50% of their time into real property businesses in which they materially participate. These qualifying taxpayers do not have passive income subject to the 3.8% tax from rental real estate activities (such as renting out commercial or residential property) in which they materially participate. If a qualifying taxpayer has not already done so, he or she may elect to aggregate into one activity all separate rental real estate interests. In general, the broader the scope of an activity, the easier it is to materially participate in it and avoid passive income subject to the 3.8% tax.