By David Myers
For those of you who don’t have the opportunity to read the tax code like I do, you may not know that the federal government has imposed a new 3.8% Medicare tax on certain investment income. Absent some up-front planning, this tax can apply to rental income that is generated when a business rents property from its owner. Many business owners set up a separate entity to own a building or other real estate and then have the operating business rent that property back from the new entity. Businesses use this strategy to help protect the property from potential liability and for tax planning purposes.
Although we still don’t have all the details about this new Medicare tax — more technically called the Net Investment Income Tax — it seems likely that businesses answering “yes” to the following questions may have an unpleasant surprise waiting for them on tax day:
a) Does your business pay rent for the use of property that you either own personally or in a separate entity?
b) Is the lease for that rental a “triple-net” lease? In other words, is the tenant responsible for paying taxes, utilities, and insurance on the property?
If you’ve answered “yes” to these questions, then it’s time for some changes. In order to avoid application of the additional 3.8% tax to this “self- rental” income, business owners should work with their professional advisors to ensure that the following actions are taken. These recommendations are based on the general rule that rental income is not subject to the additional 3.8% tax when it is “derived in the ordinary course of a trade or business” that is not a “passive activity.”
Make the Grouping Election for Section 469 Purposes
Business owners engaging in self-renting should make the election to group the rental activity with the active business activity for Section 469 purposes (assuming they are eligible to make such election). The election is made by filing a statement with the applicable tax return, although the rules differ depending on the type of entity. Once made, the election is generally irrevocable. Making the election will cause the rental activity to be considered active rather than passive (assuming the business owner materially participates in the business). However, the U.S. Treasury has taken the position that taking the election may, by itself, be insufficient to avoid the tax because the rents still must be “derived in the ordinary course of a trade or business.” In order to address that position, we recommend also taking the second action, described below.
Do Not Use a Triple Net Lease
Lease agreements for self-rented property should not be structured as triple net leases in order to ensure that there is enough activity on the part of the landlord to characterize the rents as “derived in the ordinary course of a trade or business.” The landlord’s leasing activities should be as active as practical. Such active activities include snow removal, landscaping services, and similar included services. However, the removal of any triple net lease provisions would appear to be adequate as a minimum threshold.
Although the law in this area is still unclear because the additional 3.8% tax is so new, unofficial IRS commentary suggests that the above changes will most likely protect businesses with self-rental income from the new tax. It is expected that the U.S. Treasury will provide additional guidance on this issue before the grouping election needs to be made with a taxpayer’s 2013 tax return. This election can be dated back to the beginning of the tax year. However, the decision to modify a triple net lease should be made immediately, in order to avoid the additional 3.8% tax for as much of 2013 as possible. It is expected that this requirement will be mandated under the official IRS interpretation.
In sum, in order to avoid application of the new 3.8% Medicare tax to self-rental income, we recommend immediately amending lease agreements to remove triple-net provisions, and making the section 469 grouping election with the 2013 tax return filing, subject to any additional guidance provided by the Treasury.