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