market minute: cynthia petitjean, cpa, esq. talks about the 3.8% tax on commercial real estate

the 3.8% tax on real estate sales as put forth in the affordable health care act goes in to effect january 1, 2013. tampa cpa and attorney cynthia petitjean talks about the tax and its implications.

eric: welcome to another market minute. my name is eric odum, principal real estate broker, for florida roi commercial property brokerage in tampa, florida. today, we’re going to talk about the 3.8% tax rumor that has been placed on real estate through the healthcare law recently passed under the obama administration. we are going to clear this rumor up; we have with us cynthia petitjean. cindy is a cpa and member of the florida bar since 1992. her areas of practice are estate & tax planning, tax compliance, tax controversy representation at the state and national levels, and probate administration.

eric: cindy thanks so much for joining me today.

cindy: thanks for having me.

eric: the 3.8% tax is a pretty controversial tax in the real estate world.  there’s been a lot of rumor and innuendo on how the 3.8% tax will be applied. where did this tax come from?

cindy: on march 23, 2012 congress and president obama passed “the patient protection and affordable care act”. a portion of that act implemented a code section which assessed a 3.8% tax on certain high income tax payers effective january 1, 2013.

eric: who exactly are those high income earners?

cindy: a high income tax payer is defined under this new law as a couple filing a joint return that is earning over $250,000. which i believe is just the gross income (the line on the bottom of the first page of your tax return). married filing separately couples that threshold is $125,000. head of household or single tax payers that threshold is income above $200,000. this tax is not only assessed on real estate but wages and self-employment income.

eric: is there a number attached to the sale of the property or does it have to be a particular capital gain?

cindy: there is a complex formula, but for the most part the 3.8% tax is going to be assessed on what is termed “net investment income”. net investment income is traditionally dividends, rents, interest, capital gains which you just asked about, royalties and passive activity income.

eric: i know this is complex, if someone wants to discuss their specific needs how can they reach you?

cindy: i can be reached at 813-659-2020. if you prefer to email your questions i can be reached at [email protected].

eric: in terms of amount, is everyone going to get taxed on the sale of their property?

cindy: there is a misconception that once you sell a property you will be taxed on the gain of the property. first off, there is the potential gain that an individual or a joint filling couple might recognize upon the sale of their principle residence. briefly, you can exempt up to a half million dollars of gain if you are filing a married filing jointly return or up to $250,000 of gain if you are a single tax payer on the sale of your principle residence. let me make the point that gain is not total proceeds.

so for example, let’s say you sale your house for $350,000. you may not have a taxable gain there if your basis (what you brought it for and what improvement you placed into it) is greater than $100,000. as a single person, $100,000 base minus $350,000 gross proceeds from the sale (what you received from the buyers) equates to a $250,000 gain. under current law that gain is excluded from income for a single tax payer, that gain will also be excluded from the 3.8% tax.

if you are under the threshold of excluding a gain from a principle residence you will be excluded from this tax. also the gain on the sale of non principle residence property ( i.e. property used in a trade or business) that’s sold and there’s a gain and the property is used in your trade or business that gain will also be exempt because that gain is treated as trade or business income which is not subject to the tax.

eric: i focus on commercial real estate. but there has been a lot of talk about residential real estate because in terms of value most of the property is located. i haven’t seen a lot of information out there in regards to commercial real estate so i’m glad you touched on that. let’s talk about the rules for commercial real estate and the $250,000 exclusion as it pertains to the business side.

cindy:  if the property that is used in a trade or business is sold and a gain is recognized because it’s in the bucket of a trade or business, income is not considered under the 3.8% law as net investment income. that property is not going to be taxable if sold by a person in a trade or business. let me make a point here, this 3.8% tax is on the individual. if you’re a c corporation and you sell property that’s been held as an investment this 3.8% tax doesn’t apply. this is what i call flow entities – partnerships and s corporations. it doesn’t matter what the entity, either a corporation or an llc its tax classification of partnership or s corp and the implications that occur in those entities flow through to the individual. the character of the income that is recognized by the entity flows through to the individual and that is where you apply the rules of what is net investment income vs. active trader business income.

for example: s corporation sells a piece of equipment and a gain is recognized on it. that piece of equipment if used in the act of trade or business is going to reflect a gain. that gain is going to flow through to the shareholder which is going to be active trader business income and not going to be subject to the 3.8% tax. on the other hand, that s corporation was holding a share of publically traded stock for investment purposes and it was sold for a gain. that gain will be treated as capital gain that flows through to the individual shareholder. also applying the other thresholds of high income taxpayer and other complex formulas may be taxed at the 3.8% rate.

eric: let’s talk about the reality of the situation. we’ve taken a beating in real estate market. the values of real estate have been turned back a decade. folks have probably held on to a piece of real estate for a long period of time to actually have experienced the capital gains along with the $250,000 or higher income to be subject to the 3.8% tax. is that correct?

cindy: that’s correct. let me also point out that the 3.8% tax is not only on capital gains, it is also on dividends and interest. even as important, a capital gain that might be impacted by the 3.8% tax is rent. rental real estate according to the internal revenue code is passive income unless you’re a real estate professional and can treat those rentals as an active trader business. the new law requires passive income to be subject to this net investment tax. there is some confusion about whether this tax is going to apply to rent that a person materially participates. i’m getting into complex passive activity participation rules.

eric: yes, that seems like some individual rules, they can chat to you personally about this.

cindy: there is some area of clarity in the law that we’re expecting regulations to come out but it could potentially be a point of planning.

eric: let’s talk about a high income doctor who has had real estate for a long period of time. it seems like professionals will be the most affected by this tax. i’ve has this case within the last month. a doctor who has had his building and practice for thirty years or more is thinking about how to get out. he’s at retirement age, making $280,000yr and has substantial gains on his office building. he paid $100,000 for it back in 1984 and now it’s worth five times that. sounds like this type of individual is going to be subject to this tax all away around, doesn’t it?

cindy: potentially, it depends on how the real estate is owned.  whether is owned in the entity that he’s selling and actively used in the trade or business. i’m assuming that this is his office. the gain in the real estate portion of it may be subject to the 3.8% tax, but remember this is only above certain tax payers that have a threshold.

hypothetically, if the doctor retires his income is going to drop so there’s planning opportunities to look into an installment sale of that equipment or property used in the business to keep the gain low where he doesn’t hit the threshold. if he did sell the stock of the company that stock may be subject to the 3.8%tax. depending on the format of the entity he’s selling the stock in. yes, it could impact the doctor but there are certainly planning opportunities to be looked at to make the tax implications minimal as possible to this doctor on this exit strategy.

eric: that’s a great idea cindy.  i never thought about an installment sale. what you’re essentially saying is to pull that income stream on the sale over a number of years allocating a portion of what he gets paid on this practice in the years he’s going to be earning less than $250,000. pushing him out of being subject to the tax,  is that correct?

cindy: potentially, yes, once again it depends on what the character of the income on the sale was. hypothetically, it would be ordinary income upon the sale of the assets. you do endure the credit risks of collecting your sales price over a period of years hoping you have a solvent buyer balancing the credit risk with the tax implications.

eric: that sums it up hearing it addressed from the commercial real estate aspect. i really appreciate your time and input on this cindy. once again give folks your telephone number in case they want to chat with you for future planning.

cindy: i can be reached at 813-659-2020 or if you prefer to email your questions i can be reached at [email protected]

eric: great! cindy thanks you so much for joining us. i’m eric odum, principle real estate broker for florida roi commercial property brokerage in tampa, florida and thank you for listening.

cindy: thank you eric.