In 2013 qualifying as a real estate professional will get more crucial than ever. The issue is strongly controlled by the IRS and they seem to get a great back up from the Tax Court. Until recently this has only been important to those having rental losses they want recovered. The Obamacare 3.8% tax on investment income will provoke the interest of a considerable larger group of people.
The Tax Reform Act passed in 1986 provided us with a slightly contradicting “passive activities” concept. Despite the fact that dividends and interest are considered to be “passive income”, collecting interest and dividends should not be mistaken for “passive activity”. According to Code Section 469, to have passive income or losses an individual should profit from an activity like business or trade without materially participating in it. In case of net passive losses, they will be suspended and released should you receive passive income in the future or in case the related activities get disposed of. Essentially, rent is a passive activity.
Much, but not all of business income is liable to self-employment tax. Though the flow-through income from an S Corporation is not self-employment income, the IRS might get interested if your salary is extremely low. It is not easy to define if income transferred from a business to an LLC or limited partner should be imposed with self-employment tax. The income from rental is excluded from the self-employment base and business income, not liable to self-employment tax will be liable to the net investment income tax.
However there is one exception. Non-passive income under Code Section 469 will not be liable to net investment income tax. According to this, income from renting out property may be exempt from the Obamacare 3.8% tax for real estate professionals. To those below the AGI net investment income tax threshold this might not seem too exciting until they decide to sell their real estate. To those, who decide to establish themselves as real estate professionals we recommend to watch cases like that of Sherry Hudzik for some insights.