In 2010, Federal legislators passed a 3.8% tax on some real estate transactions to help fund $210 Billion for President Obama’s Healthcare Plan and goes into effect in 2013. While it will not effect all real estate transactions, it will significantly affect commercial real estate transactions that are typically purchased with pass through entities such as Limited Liability Corporations or Sub-S Corporations. The type of entity that is common for small business owners.
In 2013, real estate transactions may have a 3.8% tax on some (but not all) income from interest, dividends, net rents and net capital gains for individuals (or entities that have pass-through income) with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.
Most small businesses are formed as pass through income entities. This income is different than W-2 income. If you own commercial real estate, the IRS does not allow you to fully deduct your expenses when they are actually paid. Property improvements must be amortized over 39 ½ years. In essence you have to deduct the cost over time in the form of depreciation, instead of taking the expense in the year it occurred in to reflect the useful life of the property.
It is not uncommon for small business income to be over $200,000 on the tax return, but since expenses aren’t realized immediately, the number is inflated. At this level, income taxes are 35% to the IRS and 8% to Minnesota. With the additional healthcare tax that is 46.8% tax rate. Commercial property taxes are typically $3.00/SF - $7.00/SF per year. To put it in perspective, a 2,000 square foot building (or small shop) would pay $6,000 - $14,000/year in property taxes. This 3.8% tax will only come into play if a property is sold or inherited, so consult your tax advisor to see how this affects you. You may want to consider selling your property this year to avoid the tax.
This legislation was passed along party lines March 23, 2010 with little or no prior discussion on this tax.
The National Associations of Realtors has a brochure with examples: