How Will the New Tax Legislation Impact Your Federal Income Tax on Rent and Royalty Income?


By George Adams

Effective in 2013, the Patient Protection and Affordable Care Act (PPACA) as amended by the Health Care and Education Reconciliation Act (HCERA) of 2010 will subject some taxpayers to a Medicare surtax of 3.8% on unearned income. This new tax applies to single taxpayers with modified adjusted gross income (MAGI) in excess of $200,000 and married filing jointly taxpayers with MAGI in excess of $250,000 or $125,000 if married filing a separate return. Taxpayers will pay this additional 3.8% Medicare tax on the lesser of:

1) The taxpayer’s “net investment income,” or
2) The taxpayer’s “modified adjusted gross income” less the applicable threshold.

Net investment income includes:

• Interest, dividends, capital gains, rent and royalty income, and nonqualified annuities,
• Income and gains from passive activities,
• Income and gains from businesses involved in the trading of financial instruments and commodities, and
• Gains from the sale of interests in partnerships and S corporations to the extent the taxpayer is a passive owner.

As it relates to investors in oil and gas programs, careful consideration will need to be taken relative to whether or not a taxpayer can treat an oil and gas income-producing activity as a trade or business. In order for the 3.8% Medicare tax to not apply, the taxpayer will need to be actively engaged in the trade or business, the income will need to be derived from the ordinary course of that trade or business and the activity cannot be a passive activity to the taxpayer (as defined under IRC Section 469).

There are several tests that must be met in order for an activity to meet the material participation test and be treated as non-passive. One of the more significant tests is that the taxpayer spends 500 hours per year or more actively engaged in the trade or business. There are planning opportunities available to make aggregation elections relative to multiple activities to ensure that the 500-hour test can be achieved through active participation in multiple activities covered by the election. HCERA provides opportunities for taxpayers to reset their elections relative to the aggregation of activities for purposes of the material participation test. The requirements related to grouping elections are beyond the scope of this article.

It is important to note that HCERA specifically states that investment income includes rent and royalty income unless it is considered the taxpayer’s trade or business. There is an even tougher standard that must be met in order to treat rental income as a taxpayer’s trade or business. The taxpayer must spend more than half of his annual personal services time in trades or businesses during the year involved with real property trades or businesses and spend a minimum of 750 hours during the year in real property related trades or businesses.

The Medicare surtax will also impact landowners that receive lease bonus payments. These payments are traditionally treated as non-passive land rent. However, the Medicare surtax applies to rental income even if it is classified as non-passive, unless the taxpayer can meet the real estate professional requirements. The preamble to the Affordable Care Act regulations is not clear as to whether rental activity constitutes a trade or business. It must be determined on a facts-and-circumstances basis.

Depending on your situation you could be caught off guard by the additional tax that will result from HCERA and the related 3.8% Medicare surtax. In some instances there are tax planning opportunities available to minimize the impact of this new surtax. Please consult your Schneider Downs tax advisor to determine what planning options may exist to implement tax minimization strategies in your situation.

© 2013 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

© 2019 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.