Medicare Tax law generally. The new Medicare Tax law (I.R.C. § 1411) was added to the Internal Revenue Code by the Health Care and Education Reconciliation Act of 2010, in part to offset some of the costs of Obamacare. Very generally, the tax is imposed on an individual's unearned income (i.e., net investment income including, in part, net income from rents and a trade or business that is a passive activity with respect to the taxpayer).
The tax does not apply to an individual who either (1) has no net investment income for the year, or (2) has modified adjusted gross income ("MAGI") equal to or less than the threshold amount ($250,000 for married filing jointly for 2013). For those taxpayer's who have both net investment income and MAGI over the threshold amount, then the 3.8% tax is levied on the lesser of net investment income or the excess of MAGI over the threshold amount.
Rental real estate investors have generally enjoyed an exception from self-employment tax on rental income. Therefore, prior to 2013 real estate investors have only been subject to the maximum 35% income tax rate on rental income (avoiding Social Security and Medicare). However, beginning January 1, 2013, real estate investors are potentially subject to a maximum federal income tax rate on ordinary rental income of 39.6%, plus the new 3.8% Medicare Tax (43.4% combined).
Nonetheless, the new Medicare Tax law excepts certain owners of rental real estate from the 3.8% tax, thus allowing those owners to continue to be subject only to the maximum income tax rates (i.e., 39.6% for tax years beginning in 2013).
The ordinary course exception. The new Medicare Tax law excepts from the 3.8% tax rental income derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer. This is essentially a two-part test as follows:
- Is the rental income derived in a trade or business?
- Is the trade or business a passive activity with respect to the taxpayer?
Unfortunately, determining whether the rental activity is a trade or business is not as easy as it sounds. The determination requires a careful look at all of the facts of the particular case. It also requires careful navigation of the many cases and IRS rulings that have addressed the issue previously.
Determining whether the activity is a passive activity with respect to the taxpayer additionally requires a thorough examination of the facts and a familiarity with the "material participation" tests under the passive activity loss rules. For instance, rental activities are per se passive unless an exception applies. One such exception is for individuals who qualify as "real estate professionals". However, once an individual qualifies as a real estate professional, they must still satisfy one of the seven material participation tests in order for the taxpayer not to be considered as passive with respect to the activity.
If taxpayers can satisfy both parts of the test, then they can avoid the new 3.8% Medicare Tax on their rental income.