How to navigate the Passive Loss Rules Labyrinth, continued from Part III

The Passive Loss Rules Labyrinth: Real Estate Professionals and Material Participation. This is the fourth of IV parts.

By Gary Krupa, CPA

Updated September 5, 2021

How to avoid having to pay the Net Investment Income Tax (NIIT)

This tax first became effective in 2013. It’s based on (a) your net investment income or (b) the excess of your Modified AGI* over a certain threshold. The threshold is $250,000 for married taxpayers, $200,000 if you’re single, and $125,000 if you’re married filing separately. You’d pay 3.8% on (a) or (b), whichever is less.

Here are the NIIT avoidance requirements. You must earn or receive rental income in the ordinary course of a trade or business. You must also materially participate in the rental activity.

A Safe Harbor enables you to meet the first requirement. To start with, you must qualify as a Real Estate Professional. Then you must spend at least 500 hours in the activity. This can either be in the current year or in any five of the last ten years.

If you satisfy the Safe Harbor provisions, you’ll receive two benefits. One, your rental income won’t be considered net investment income. Two, if you have a gain on the sale of your rental property, it won’t be considered net investment income either. Either way you won’t have to pay the NIIT. YES!

By combining rental activities, you can avoid paying the NIIT. As explained above, doing this also helps to establish material participation.

Do you remember this from what I said previously? You’d make a Sec. 1.469-9(g) election to
aggregate all rental income. Not only will it help you establish material participation. It will also enable you to satisfy the above 500 hr. safe harbor.

Disposing of your rental activity

You may wish to skip making the Sec. 1.469-9(g) election in this instance. You may have suspended passive losses from a rental activity you intend to dispose of. If you dispose of your entire interest in the activity in a fully taxable transaction** it’ll free up the suspended losses.

It will likely also permit you to pay less in taxes than if you deduct the losses currently.

Photo courtesy of Luminous Realty in Sedona.

For more information

For more on the Passive Loss rules, read my previous article The Passive Loss Labyrinth, Part I.

This article applies the passive loss rules to the sale of your rental property: What Happens to Suspended Passive Losses When You Sell (Or Lose) Your Rental Property?

*Adjusted Gross Income

** “A fully taxable disposition includes a bona fide and arm’s length sale of the property to a third party for a price equal to its value (Senate Report p. 725).” Source: Real Estate Tax Planning, by Danny Santuccci, J.D., published by Beacon Hill Financial Educators, 3/20/2020, chapter 6 “Passive Loss & At-Risk Rules”.