Accountants and tax preparers need to have a clear understanding of the tax implications which follow from the passive income deriving from rental property. They should have a firm grasp of their additional federal tax burden and the mechanics of the net investment income surtax. Both of these taxes are typically unfamiliar to the average taxpayer. Accountants and tax preparers should also have an understanding of the provisions of Revenue Procedure 2008-16. Rev. Proc. 2008-16 provides a “safe harbor” – meaning that the property won’t be challenged by the IRS – when taxpayer observe its guidelines.
Tax Considerations of Rental Income
When clients convert a second home into a rental property, tax planning considerations usually take a back seat to other considerations. Most clients are more concerned about other things associated with the conversion, such as managing the additional income. In many cases, clients convert a second home in order to more quickly pay off the second mortgage which was taken out to acquire the home; or, they convert to pay off other debts. Clients need to plan ahead for the resultant tax liabilities which will follow from the additional income. Accountants and tax preparers can assist in this area by relaying information regarding additional federal income tax and the net investment income tax (NIIT). The NIIT may not always apply in every case, however, as it only applies to certain income thresholds.
• Federal income tax
When a client converts a second home into a rental property, the income generated will be classified as “passive income,” and it will be included as ordinary income on the client’s tax return. To give counsel, accountants and tax preparers should memorize the current federal income tax rates and be able to recite those rates for rental property owners with ease. In some cases, rental property owners may jump into a higher marginal tax bracket as a consequence of the additional income received via rental property. Currently, individual income tax rates vary from a low of 10% to a high of 37%. You should be familiar the thresholds which correspond to each of the brackets within this graduated tax structure for your clients.
• Net investment income surtax
Another thing which clients need to be aware of is the so-called “net investment income tax,” or NIIT. The NIIT was put into place to boost funds for Medicare. The NIIT consists of an additional 3.8% surtax on investment income beyond the maximum 20% for long-term capital gains. The NIIT only kicks in at certain high-income levels, so it will only apply for those who have substantial investment income in a given tax year. As a general rule, the rental income generated from a rental property will be included in the calculation of total investment income for NIIT purposes. In other words, in most cases, if a client generates an additional $20,000 in rental income, that $20,000 will be counted together with other investment income generated during the year. Therefore, it’s possible that a client’s rental property activities will either trigger the NIIT or create an extra liability in a situation in which the NIIT is already applicable. The mechanics of the NIIT are fairly complicated, so accountants and tax preparers should spend time mastering the mechanics so that they can properly advise clients.
However, the rental income generated from a rental property won’t always be included with investment income. Depending on how the rental property is treated, the income may be excluded from the reach of the NIIT. If a client is “materially” participating in the generation of the rental property income – and the term of “materially” is defined according to certain criteria – then the income may be excluded from the investment income for NIIT purposes.
Complying with the Provisions of Revenue Procedure 2008-16
Another important area of concern which accountants and tax preparers should be able to touch on is the income generated from the sale of a second home converted to a rental property. If a client wishes to dispose of the second home in a traditional sale, then the client will face a tax liability based on the recognized gain. The client may also face depreciation recapture taxation based on the depreciation deductions taken during the course of ownership. The gain will be subject to the applicable capital gains tax rate. Currently, for long-term capital gains, the rates are 0%, 15% and 20%. Accountants and tax preparers need to keep up with the capital gains tax rates as these may change at some point in the future.
If a client wishes to dispose of the second home rental property in a 1031 exchange, rather than a traditional sale, then you will need to give more sophisticated counsel. Clients will want to comply with the guidelines of IRS Rev. Proc. 2008-16 so that they can stay within the safe harbor provided by these guidelines. If clients abide by these guidelines, they won’t need to worry that their exchange will be challenged based on a possibly faulty “holding” period. The holding period refers to the intent of the owner to hold the property as a capital asset. Section 1031 allows taxpayers to defer recognition of gain when they exchange their investment or business property for another like-kind investment or business property. To stay within the purpose of this section, the property must be “held for” investment or business reasons, and this held for requirement is based on the subjective intent of the taxpayer.
To curtal unnecessary and expensive litigation, the IRS has put out Rev. Proc. 2008-16 so that taxpayers can conduct an exchange without worrying about the status of the holding requirement. Rev. Proc. 2008-16 lays out use requirements. Before selling their rental property in an exchange, clients should own the property for a minimum of 24 months. During this 24-month period, clients should rent out the property at a fair market price for at least 14 days in the two 12-month segments of time which add up to the 24 months. In other words, in the first year they rent out the property for at least 14 days, and in the second year they should do the same. Clients must not reside in the rental property for more than 14 days per year, or more than 10% of the total number of days the rental property is rented out during each year. These are important guidelines, and accountants and taxpayers must remember to give accurate counsel in this area. If clients don’t stay within these guidelines, the litigation could be costly, and the underlying exchange itself could fail, with harsh financial consequences.
This article was written by Jorgen Olson, a writer based in Seattle, on behalf of Sammamish Mortgage, a mortgage company based in Bellevue, WA.