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New Final and Proposed Section 1411 Regulations Change Tax Treatment for Net Investment Income Tax


12/18/13

Synopsis:
 
The IRS released final and proposed regulations for the net investment income (NII) tax. Notably, the final regulations provide guidance on regrouping for passive activity loss purposes and clarification on whether certain rentals will be subject to the tax.
 
Issue:
 
Section 1411 of the Internal Revenue Code, enacted as part of the Affordable Care Act, imposes a new 3.8% NII tax. For tax years beginning after December 31, 2012, individuals, trusts, and estates pay this surtax on their net investment income for the year if their adjusted gross income exceeds certain thresholds ($200,000 if filing single and $250,000 if filing married filing jointly). For the purposes of this law, “net investment income” is generally defined as income from three categories:

  • Gross income from interest, dividends, annuities, royalties, and rents not derived in the ordinary course of a trade or business;
  • Income derived from a trade or business that is passive activity with respect to the taxpayer or income from a financial trade or business; and
  • Net gain from the disposition of property that is not held in a trade or business.
     

The final regulations to the NII tax clarify many questions from the old regulations. Overall, the general framework of the NII tax remains unchanged. In some areas, the IRS provided relief to taxpayers by allowing them to exclude various types of income from the NII tax.
 
The final regulations clarified the following topics:

  • Regrouping. The regulations added provisions for and mechanics of regrouping for purposes of the passive activity loss rules. Under the final regulations, a taxpayer may regroup its activities if subject to the NII tax. Regrouping will not be allowed for partnerships and S Corporations. Only those individuals, trusts, and estates subject to the Section 1411 tax may regroup their activities.
  • Self-rented property.  Under the final regulations, if gross rental income is not treated as derived from a passive activity, it will be deemed as derived from the ordinary course of a trade or business.
  • Self-charged interest income. The regulations provide a special rule that permits taxpayers to exclude self-charged income equal to the taxpayer’s allocable share of the non-passive deduction. This special rule does not apply when determining self-employment income.
  • Trader’s gains and losses. Net losses from the disposition of property are now fully allowed under the new regulations, and are deductible to a trader.
  • Real estate professionals. The final regulations provide a safe harbor for the rental income of real estate professionals.  If the real estate professional satisfies the 500 hour threshold of participating in rental real estate activities, their rental income will be deemed to be income from the ordinary course of a trade or business, and thus not subject to the NII tax.
     

Lastly, the final regulations withdraw the method for calculating net gain or loss from the disposition of a pass-through entity and re-propose new regulations with an optional simplified reporting method. The proposed regulations include revised rules regarding the calculation of net gain from the disposition of a partnership interest or S Corporation stock. The proposed guidance also describes the treatment of guaranteed payments, payments to retiring or deceased partners, and capital loss carryovers. Finally, the proposed regulations provide an optional, simplified method to report disposition of partnership interests or S Corporation stock.
 
What Does CohnReznick Think?
It is important to note that after December 31, 2012, taxpayers subject to Section 1411 may regroup their activities without regard to groupings made in previous years. Real estate professionals may receive some relief by grouping certain self-rental income with their other ordinary trades or businesses. Other taxpayers that can elect to group all rental real estate activities and materially participate in a trade or business will not be subject to the NII tax. This standard of material participation relies on the taxpayer’s material participation in a trade or business, instead of participation as outlined in the passive activity rules.

As for traders, the final regulations change the rules significantly. Contact your CohnReznick tax professional to see how the rules apply to your situation.
 
For more information, please contact Thomas Nice, Partner, at 301-961-5542.
 
To learn more about CohnReznick’s Tax Services, please visit our website.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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