Real Estate and the Net Investment Income Tax and Self-Employment Tax

If you are planning or are actually doing a real estate business, either as an investor or as an active participant, you will have to deal with these:

Net Investment Income Tax: If you have net investment income and your modified adjusted gross income exceeds $250,000 for married persons filing jointly, then there is a 3.8% tax on the lesser of (1) your net investment income, or (2) the amount your modified adjusted gross exceeds the threshold amount. Note that self-employment income is not net investment income.

The Self-Employment Tax: this tax is comparable to the FICA and Social Security taxes that are taken out from someone’s salary. If it is a salary, the employer pays one half and the employee pays the other half. A self-employed person gets to pay both hands, amounting to approximately 15.3% of self-employment income. Note that net investment income is not self-employment income.

Some taxpayers who have an S Corporation attempt to avoid paying any Social Security taxes by taking distributions from the Corporation, rather than a wage or salary. Thus, it is likely to be unreasonable that a full time real estate professional who is working for the Corporation will not have a reasonable wage, according to the Internal Revenue Service. If you don’t take any salary, then there will be an easy issue for the IRS assert against you.

Note that in the instructions to Form 1120S specifically states on line 8, Page 13: “Line 8. Salaries and Wages Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

Of course, “reasonable,” is a debatable point, however $0 is seldom an arguable point. It would be an easier position, and more prudent, if you had some earnings from wages. Note that on the Form 1120S the very 1^st line on page 1 in the deduction section lists compensation for officers.

On the Net Investment Income Tax, the Form 8960. All income is first listed and on the line below it, income from an active participation is deducted, leaving the amount that will be exposed to the tax. You can deduct net income from active participation in some entity, which usually means you are putting in 500 or 750 hours of effort and work to convert an investment income into a participating income and not being exposed to this tax. You should consult someone familiar with this issue as to which test you have to meet, or if you should meet it at all.

The issues are far more complex if the entity is a limited liability company, as what constitutes active participation can vary depending upon if there is a professional practice involved. One should consult proposed regulation §1.1402(a)-2 (h) a discussion of how one LLC will get taxed. The operating agreement of the LLC will make a substantial difference. If you are forming an LLC, it would be wise to consider the impact of these taxes and whether they should be assessed at all.

Have a question? Contact Brett Thompson. Your comments are always welcome!