Final section 1411 regulations

On Nov. 26, 2013, the IRS released final regulations and a notice of proposed rulemaking regarding the 3.8 percent net investment income (NII) tax. This Tax Alert provides a brief overview of the major provisions of the new rules.

Background. For tax years beginning after Dec. 31, 2012, individuals, trusts, and estates are subject to a surtax on “unearned income” (i.e., the tax is in addition to any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “NII tax,” is 3.8 percent of the lesser of (1) NII or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). The threshold amount is not indexed for inflation. MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under § 911(a) (net of the deductions and exclusions disallowed with respect to the foreign earned income). NII includes capital gains, dividends, annuities, royalties, interest, rents, and income from passive activities.

Final regulations. The final regulations include significant changes to the proposed regulations and address many concerns taxpayers had raised with the IRS, such as rules on regrouping, self-rented property, self-charged interest income, and real estate professionals. The new rules provide safe harbors for rental real estate activities of a real estate professional and self-rented property and acknowledge that a single rental property may rise to the level of a trade or business in certain situations.

The final regulations also propose new rules for calculating net gain or loss from the disposition of a pass-through entity, including an optional simplified reporting method. The IRS and Treasury Department did not resolve certain issues—e.g., the definition of a trade or business, material participation of trusts and estates—noting that these questions go beyond the scope of the project.

Activity regrouping          

One of the most favorable aspects of the regulations is that they allow a regrouping “fresh start” under the passive activity rules for certain taxpayers. To be eligible to regroup, a taxpayer must have MAGI that exceeds the applicable threshold amount and have NII. The final regulations clarify a number of issues related to regrouping.

  • Under the final regulations, taxpayers are allowed to regroup on an amended return, but only if the taxpayer was not subject to section 1411 on his or her original return, and if, because of a change to the original return, the taxpayer owed tax under section 1411 for that taxable year.
  • Additionally, if a taxpayer regroups on an original return (or previously amended return) under these rules, and then subsequently determines that they are not subject to section 1411 in that year, such regrouping is void in that year and all subsequent years until a valid regrouping is done.
  • The final regulations do not allow regrouping by partnerships and S corporations.

Self-rented property

Businesses are often structured placing the operating business and the real property in separate entities, with the operating business renting the property from the real estate entity. The final regulations provide a special rule for self-rented property.

  • If rental income is treated as nonpassive because of the income recharacterization rule or because the rental activity is properly grouped with a trade or business activity (and the grouped activity is nonpassive), the gross rental income is deemed to be derived in the ordinary course of a trade or business and thus not subject to the 3.8 percent NII tax. This is a significant improvement over the proposed regulations where it appeared that these self-rentals would be subject to the 3.8 percent tax.
  • In both of these situations, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as nonpassive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a nonpassive trade or business.

Self-charged interest

The final regulations also include a special rule that addresses self-charged interest.

  • In the case of self-charged interest received from a nonpassive entity, the amount of interest income excluded from NII is the taxpayer’s allocable share of the nonpassive deduction.
  • This rule does not apply where the interest deduction is taken into account in determining self-employment income.

Real estate professionals

The final regulations provide a safe harbor offering relief from the 3.8 percent NII tax for rental income of real estate professionals derived in the ordinary course of a trade or business.

  • The safe harbor provides that if a real estate professional participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business, and thus not subject to section 1411. We are pleased to note that the 500-hour safe harbor was suggested by Baker Tilly during the comment period for the proposed regulations.

CAUTION: The preamble to the final regulations states that “not all of the material participation tests provide conclusive evidence that a taxpayer is regularly, continuously, and substantially involved in a rental trade or business within the meaning of section 162.” Therefore, the only test that is applicable for this safe harbor is the 500-hour test.

Trade or business / rental real estate

Despite receiving multiple comments regarding the determination of a trade or business within the context of rental real estate, the Treasury and the IRS declined to provide guidance on the meaning of trade or business solely within the context of section 1411.

  • The preamble to the final regulations acknowledges that, in certain circumstances, the rental of a single property may require regular and continuous involvement such that the rental activity is a trade or business within the meaning of section 162. However, the Treasury and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law.
  • In making the trade or business determination, there are a number of relevant factors, including but not limited to the type of property (commercial real property versus a residential condominium versus personal property); the number of properties rented; the day-to-day involvement of the owner or its agent; and the type of rental (for example, a net lease versus a traditional lease, short-term versus long-term lease).

In order for the net rental income to escape the 3.8 percent tax, it must rise to the level of a trade or business. You should review your particular fact pattern with your tax advisor regarding your rental activities.

Proposed regulations on gain from disposition of partnership interests

The IRS also issued proposed regulations that include revised rules regarding the calculation of net gain from the disposition of a partnership interest or S corporation stock. The proposed guidance also addresses the treatment of section 707(c) guaranteed payments for capital, section 736 payments to retiring or deceased partners for section 1411 purposes, some capital loss carryovers, and special rules on charitable remainder trusts.

For more information or any questions you might have on this topic, please contact your Baker Tilly advisor or send an e-mail to tax@bakertilly.com.