The new federal Net Investment Income Tax became effective in 2013, making this the first year that we are seeing its effects on tax returns. It’s a 3.8 percent tax on net investment income, which is intended to help finance the federal Affordable Care Act.
The accounting profession has told people for a couple of years that this was coming, but it’s still generating confusion.
This tax kicks in for incomes greater than $250,000 for those who are married and filing a joint return. It is having the greatest impact on entrepreneurs and investors because it applies to gains from any kind of activity that is not related to their primary career.
For example, a company’s CEO may invest in a lawn care business, hiring others to do the work. This makes him a “passive investor” and his profit from that lawn care business will be subject to the 3.8 percent tax. Similarly, income or gains from the sale of rental property may also be subject to the Net Investment Income Tax.
The two areas where we are seeing the greatest impact of this new tax are real estate and family businesses.
Real estate
If you are married and have lived in the home you are selling for at least two of the last five years, there is no tax on gains less than $500,000. But if you sell a vacation home that is not your primary residence, that is a taxable gain and will more than likely be subject to the 3.8 percent tax.
This tax also kicks in at just $12,000 of income for real estate that is held in trusts, meaning it could lead to changes in how people pass on their assets to others.
To avoid paying this tax on gains from real estate investments, it is important to be declared a real estate professional. To be classified as such, you must be able to document that you’ve spent more than 700 hours during the year performing qualified real estate professional services such as property management, brokering, development, construction or even buying and flipping houses.
In addition, those 700 hours must equate to more than half of your service time. If you can meet both of these requirements, then none of your real estate income or gains on property sales will be subject to the new 3.8 percent tax.
Those who are in real estate full time will find it simple to meet this definition. But if you dabble in real estate on the side, it’s going to be difficult.
For example, if you work 2,000 hours in another full-time job, you would need to also perform 2,001 hours in the real estate business to qualify as a real estate professional. Reaching that level of service hours is unlikely. If you fall into this category, it becomes important to plan ahead to try and qualify as a real estate professional before you recognize large gains.
Family businesses
This new tax is affecting family businesses where children are allocated income through ownership in the company, yet aren’t actively involved with day-to-day operations. Even if every owner receives the same amount of income, those who are classified as passive business participants will be taxed the additional 3.8 percent, while those classified as material participants will be exempt from this new tax.
There are seven tests to see if you qualify as a material participant. The primary test states that you must have spent at least 500 hours actively involved in the business. That equates to 10 hours per week for 50 weeks. This can be difficult to document for most entrepreneurs as they typically don’t fill out time cards. So it becomes vitally important to maintain a calendar so that all time invested in the business can be substantiated.
Another win/win opportunity to avoid paying the 3.8 Net Investment Income Tax is to donate appreciated assets to charity. This way, you’ll also receive a tax deduction for your contribution.
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