Editor: Kevin D. Anderson, CPA, J.D.
Effective for tax years beginning after Dec. 31, 2012, Sec. 1411 imposes an additional 3.8% tax on “net investment income” of individuals, trusts, and estates. The tax is imposed on the lesser of the net investment income amount or the excess of the taxpayer’s modified adjusted gross income (MAGI) over a “threshold amount.” For individuals, the threshold amount is $200,000 ($250,000 for joint filers and $125,000 for married individuals filing separately).
Net investment income, as defined in Sec. 1411(c) and Prop. Regs. Sec. 1.1411-4, encompasses portfolio income, such as interest, dividends, royalties, and capital gains, as well as income from the business of trading in financial instruments or commodities. The definition also includes rental income unless the income is derived in the ordinary course of a trade or business as defined in Sec. 162 and is not subject to the passive activity loss rules of Sec. 469.
Proposed Regs. Refer to Secs. 162 and 469
Proposed regulations under Sec. 1411 (REG-130507-11) provide that whether a taxpayer’s activity is considered passive for purposes of the 3.8% tax is determined in accordance with the principles of Sec. 469, which deals with the disallowance of passive activity losses. In addition, the proposed regulations state that “trade or business” for purposes of Sec. 1411 has the same meaning as under Sec. 162, which permits deduction of ordinary and necessary expenses paid or incurred in carrying on a trade or business.
Trade or Business Under Sec. 162
Under Secs. 162(a) and 62(a)(1), a taxpayer’s adjusted gross income is computed by deducting all ordinary and necessary expenses incurred in carrying on a trade or business. “Trade or business” in this context, however, has not been defined in the Code, regulations, or IRS guidance. Thus, there are no uniform standards, and the determination whether a taxpayer’s activities qualify as a trade or business is made on a case-by-case basis. Nonetheless, the preamble to the proposed regulations notes that “[t]he most established definition of trade or business is found under section 162(a)…. The use of the section 162 definition of trade or business facilitates administration of section 1411 and should simplify taxpayer compliance.”
The Supreme Court has identified regularity (i.e., activity over a certain period) and a profit motive as factors that the courts have widely accepted as indicating the presence of a trade or business. The Court in Groetzinger, 480 U.S. 23, 35 (1987), said, “We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” (See also Higgins, 312 U.S. 212 (1941); Stanton, 399 F.2d 326 (5th Cir. 1968); and Dagres, 136 T.C. 263 (2011).)
However, determining the extent of activity required for the rent and management of real property to reach the status of a trade or business is particularly difficult. When is a taxpayer owning rental properties considered to be in the trade or business of renting real estate? The IRS discussed the concept of real estate trades or businesses in Letter Ruling 9840026 in the context of Sec. 108(a)(1)(D), which allows taxpayers to exclude cancellation-of-debt income if the debt is incurred or assumed in connection with, and is secured by, real property used in a trade or business. In the letter ruling, the IRS acknowledged that there are no uniform gauges and concluded:
The issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business.
Real Estate Trade or Business Under Sec. 469(c)(7)
Sec. 469(a) generally disallows any passive activity loss for a tax year. A passive activity is defined as any trade or business in which a taxpayer does not materially participate. Under Sec. 469(c)(2), a rental real estate activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates.
However, Sec. 469(c)(7) and Regs. Sec. 1.469-9 provide an exception under which the rental activities of a taxpayer who is considered a real estate professional are not treated as per se passive activities. Instead, the rental activities are treated as a trade or business and are subject to the material participation requirements to be considered nonpassive for purposes of Sec. 1411. Under Sec. 469(c)(7)(B), a taxpayer is considered a real estate professional if:
- More than half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which the taxpayer materially participates; and
- The taxpayer performs at least 750 hours in real property trades or businesses in which he or she materially participates.
Under Sec. 469(h)(1), a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Material participation is further determined by the taxpayer’s meeting at least one of the seven tests in Temp. Regs. Sec. 1.469-5T(a). While most of the tests are quantitative, the seventh test is more subjective and is based on facts and circumstances. This test, similar to the guidelines under Sec. 162, provides that a taxpayer materially participates in a trade or business if the taxpayer participates on a regular, continuous, and substantial basis during the year.
The Tax Court has held that although a taxpayer materially participated in rental activities, where the taxpayer did not qualify as a real estate professional, his real estate activities were per se passive (Ani, T.C. Summ. 2011-119). Conversely, qualifying for real estate professional status only relieves a taxpayer of the per se passive rule of Sec. 469(c)(2). Absent an aggregation election (discussed below), a taxpayer with more than one rental activity still has to materially participate in each activity.
The preamble to the proposed regulations clarifies the necessity of meeting both the trade or business test and the real estate professional test by addressing how Sec. 1411 interacts with the special rules for taxpayers engaged in real property businesses under Sec. 469(c)(7):
- A taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business within the meaning of Sec. 162 with respect to the rental real estate activities.
- If the rental real estate activities are Sec. 162 trades or businesses, the rules in Sec. 469(c)(7) and Regs. Sec. 1.469-9 apply in determining whether a rental real estate activity of a real estate professional is a passive activity for purposes of Sec. 1411(c)(2)(A).
- If the rental real estate activities of the real estate professional are not Sec. 162 trades or businesses, the gross income from rents derived from the activity are not excluded by the “ordinary course of a trade or business” exception under Sec. 1411(c)(1)(A)(i).
Aggregation Rules for Passthrough Entities
The rules make it clear that material participation in an activity conducted through a passthrough entity such as a partnership or an S corporation is determined at the partner or shareholder level, respectively. If a partner or shareholder actively participates in each passthrough entity in varying degrees, absent an aggregation election to group activities, the owner might not meet the material participation requirement for each separate activity.
Sec. 469 allows taxpayers to elect to group trade or business activities into a single activity for purposes of the material participation tests. To do so, the trades or businesses must form an appropriate economic unit under Regs. Sec. 1.469-4. The taxpayer’s Sec. 469 groupings must be consistent from year to year unless the facts and circumstances materially change or the taxpayer’s original groupings were not appropriate.
The initial Sec. 469 groupings are made by the entity; the owners may then further group activities with their separate activities. Sec. 469 allows this aggregation of income and loss from all passive activities to determine whether a taxpayer has income or loss. If the total aggregation is positive, resulting in rental real estate income, and the taxpayer qualifies as a real estate professional, it appears that the taxpayer must then determine whether the rental income is derived in the ordinary course of a trade or business under Sec. 162 for purposes of the additional 3.8% tax on net investment income.
If the taxpayer elects to aggregate the separate real estate activities and meets the real estate professional test under Sec. 469(c)(7), the taxpayer might continue to be subject to the 3.8% tax if the taxpayer cannot meet the test under Sec. 162. In this case, the positive nonpassive real estate taxable income and the related 3.8% tax cannot be offset by other non–real estate passive losses that are suspended due to the basis rules under Sec. 704(d), the “at-risk” rules under Sec. 465, or the passive activity loss rules under Sec. 469. Once the suspended losses are freed up, they may reduce or eliminate the 3.8% tax in later years.
If a taxpayer has suspended losses from passthrough entities, these losses cannot offset portfolio income from other sources (i.e., interest, dividends, or royalties) to reduce the 3.8% tax. Moreover, losses disallowed under other statutory provisions (e.g., net capital losses under Sec. 1211, the Sec. 212 limitation, related-party losses disallowed under Sec. 267, and partnership disguised sale losses under Sec. 707) cannot offset other passive income items subject to the 3.8% tax.
Implications and Observations
Real estate owners whose properties are profitable must determine whether the income is derived from a nonpassive activity and, if so, whether their activities rise to the level of a trade or business. Only where both conditions are met may the income be outside the scope of the 3.8% tax. A taxpayer owning a building that is triple net leased to long-term tenants might not be able to substantiate an exemption from the net investment income tax on this income stream or on any gain from a sale of the property subject to the triple net lease. On the other hand, a taxpayer significantly involved in the real estate activities may, with proper tax planning and documentation, be able to avoid the 3.8% tax.
The proposed regulations under Sec. 1411 do not provide a definition of “trade or business” for purposes of taxpayers engaged in rental real estate activities and thus potentially subject to the tax on net investment income on income from these activities. Going forward, the practical application of Sec. 1411 and subsequent judicial and IRS guidance may bring clarity to the definition of a trade or business for purposes of real estate activities. It is also hoped that some clarity will be brought to the interaction of the aggregation rules with the “ordinary and necessary” business expense test under Sec. 162.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.