If you’re a business owner, it often makes sense to rent from yourself, taking advantage of office or warehouse space you own. Your business pays rent to the owner—you—and deducts the rental payments as legitimate business expenses. And although you’re taxed on the rental income, you can offset some of that with expenses you incur. It’s a win-win situation.
However, a new tax provision that took effect for the 2013 tax year can throw a monkey wrench into the works. Under regulations the IRS recently issued, such “self-rental” income may be subject to a special 3.8% Medicare surtax.
The 3.8% Medicare surtax applies to the lesser of (1) net investment income (NII) or (2) the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount. That threshold is $200,000 for single filers and $250,000 for joint filers. Business landlords who have income from various sources easily can find themselves subject to the tax.
For this purpose, net investment income includes items such as interest, dividends, annuity distributions, rents, royalties, and net capital gains on property you sell. Significantly for business owners, it also includes income derived from passive activities. Net investment income doesn’t include salaries, wages, or bonuses, distributions from IRAs or qualified plans, income used to calculate self-employment tax, gains from selling an active interest in a partnership or S corporation, or income from tax-exempt bonds and other items not subject to income tax.
Surprisingly, when the IRS issued regulations on the 3.8% Medicare surtax, it diverged from the traditional treatment of self-rental income. It said that in this case, such income will be treated as passive income, rather than income from an active trade or business. As a result, self-rental income is subject to the 3.8% surtax.
Suppose that Jerry and Mary own a building they rent to their jointly owned business. They receive $300,000 in rental income annually, but can offset that amount with $101,000 in depreciation and other expenses. Therefore, their self-rental income is $199,000 for the purpose of the 3.8% surtax calculation.
If, counting the self-rental income, Jerry and Mary have a MAGI of $250,000 or less, they won’t have to pay the 3.8% surtax. However, if their MAGI is, say, $500,000, they’ll be hit with the 3.8% surtax on the self-rental income, to the tune of $7,562 (3.8% of $199,000). Any additional NII items will increase the surtax.
While the new surtax may not negate the other advantages of renting space to your own business, it is important to know what to expect before your prepare your taxes. Your tax advisor may be able to suggest strategies for minimizing the impact of the new tax.
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