If you are subject to the federal net investment income tax (NIIT), you could be paying as much as 3.8% more on your income taxes. Rental property owners are often subject to this additional tax, depending on their total income and how they structure their business.
Here are the two criteria the IRS uses to determine if you are required to pay NIIT:
For NIIT purposes, your MAGI will likely be the same as your adjusted gross income (AGI). This is your gross income minus any above-the-line tax deductions. The federal tax code modifies the NIIT AGI only for certain U.S. citizens or residents who live abroad.
If you are subject to paying NIIT, you will pay 3.8% on the lesser of:
You may qualify as a real estate professional per the NIIT tax code. If you do, you will have some specific tax advantages:
The second tax advantage above may depend on if your rental activity qualifies as a business for tax purposes.
To qualify as a real estate professional, you or your spouse (if filing jointly) must spend over 50% of your work time in a real estate business or businesses. In addition, you mush spend over 750 hours working in real estate businesses during the year.
In addition to being qualified as a real estate profession per NIIT tax codes, you must materially participate in your rental activity if you want to deduct your losses and/or qualify for the NIIT exemption. There are actually seven ways to establish your material participation. However, the two most common are:
Lastly, your rental activity must qualify as a business and not just a casual investment. This is per IRC Section 162. Most rental activities are considered businesses, even if reported on Schedule E. The legal tax definitions are somewhat vague, so consult with your tax advisor to make sure your rental activity qualifies as a business per NIIT regulations.
Your rental property will be considered a short-term rental if the average tenant stay is less than seven days or when it is less than 30 days and you provide hospitality services such as cleaning or laundry. A short-term rental is exempt from the tax-law-defined real estate professional rules. You will need to materially participate in the property to deduct your losses on a short-term rental.
You will not be subject to NIIT on your short-term rental if you materially participate and the rental is a tax-code-defined business.
Passive income from rental property that would otherwise be subject to the NIIT is recharacterized as non-passive if your rent the property to a business in which you materially participate. In other words, income from self-rentals is not included in the net investment income. Self-rentals can be tricky for tax purposes, so be sure to consult with your tax advisor.
To learn more about the NIIT and how it may affect your rental property income or other real estate investments, contact Illumination Wealth today.