Real Estate and the So-Called Medicare Tax

Somewhat lost in the welter of caterwauling and chaos surrounding the Affordable Care Act rollout was a 3.8 percent tax on certain investment income that included real estate and exempted qualified real estate professionals.

Congress passed the so-called Medicare tax in 2010, and it went into effect on Jan. 1 of this year. It applies to individuals with adjusted gross incomes above $200,000 and joint returns with an AGI of more than $250,000. Capital gains on the sale of a primary home totaling less than $250,000 for an individual and $500,000 for joint filers are still exempted. But the Medicare tax has ruffled feathers even if it affects a small and affluent group of people and transactions.

Real estate professionals are spared the pain, being exempt from the Medicare, net investment income and additional self-employment taxes on income from rental real estate. Of course, that’s assuming they qualify. To do so, they must devote more than half of their professional time—or 750 hours per year—to real estate activities like managing, developing, operating and brokerage work. They must also “materially participate” in the rental real estate sector.

There are seven or eight thresholds that can determine material participation. One is spending more than 500 hours on a rental property or activity. Another is spending at least 125 hours on “very significant” participation. A third criterion is that the individual spends more time than anyone else on the property or activity.


But despite the allure of evading the 3.8 percent tax, it’s unclear what effect it will have on real estate transactions.

When a real estate professional’s attention does shift to the tax—or his exclusion from it—the biggest change may have to do with the documentation required to stay in the Internal Revenue Service’s good graces. Anybody who does real estate thinks he’ll qualify,. And just telling the IRS you’re a real estate professional ain’t gonna cut it.

Other real estate issues stemming from the tax affect triple-net leases, whose owners are unlikely to qualify as material participants. And real estate dynasties may be in for a surprise, since children who own property but don’t actively manage it will have to pay up. Finally, sources said they’d handled a rising tide of 1031 like kind exchanges, thanks in part to the 3.8 percent tax.