Investment Income
This category includes income from interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payments. In general, the definitions in this category are straightforward with the following exceptions:
Gross Income From Dividends Includes
Corporate dividends; constructive dividends; amounts treated as distributions under Section 1248(a), relating to the gain from the sale of stock in a controlled foreign corporation; and amounts distributed by an S corporation that are treated as a dividend by the distribution is deemed to have come from earnings and profits accumulated in prior C corporation years. In the preamble to the proposed regulations, the IRS clarified that capital gain dividends from mutual funds and real estate investment trusts (REITs) are to be included as net gain attributable to the disposition of property not as dividend income.
Annuity Income
Other than from qualified plans, of any type, including from annuities purchased pre-2013, is subject to the tax. However, a deduction is allowed for the Code Sec 72(b)(3) unrecovered basis in a decedent’s annuity (Reg. Section 1.1411-4(f)(3)(iv)).
Exceptions to Being Classified as Investment Income
There are four exceptions to being classified as investment income in this category:
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Tax-exempt interest earned on state and local tax-exempt bonds.
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Distributions from qualified pension plans.
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Interest paid to an employee by an employer under a nonqualified deferred compensation plan.
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Income earned in the ordinary course of a trade or business.
Rental Income
Before the proposed regulations for Sec 1411 were released many believed that qualifying as a real estate professional and materially participating in a rental activity would shield the rental income from the 3.8% unearned income tax. However, that is not enough. According to the preamble of the regulations, to be excluded each rental must meet the following criteria:
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Is engaged in a trade or business under the meaning of the tax law (measured at the business level).
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The income must be earned in the ordinary course of the trade or business (measured at the business level).
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The income must not be passive to the individual owner (determined at the owner level).
Being a real estate professional satisfies requirements b) and c) but what about a), the requirement to be engaged in a trade or business?
Definition of a Trade or Business
There is no bright line definition of a trade or business in the over 70,000 pages of the tax code. The IRS in the final regulations relies in part on Sec 162 – Trade or Business Expenses – to help define a Trade or Business. The determination can be subjective, and the regulations generally leave the determination to the taxpayer (or his preparer) to get it right.
In order for a rental activity to rise to the level of a trade or business, the taxpayer’s involvement in the activity must be regular, continuous, and substantial. Key factual elements that may be relevant in determining if the rental rises to the level of a trade or business include, but are not limited to, the following, according to the IRS in the preamble to the final regulations:
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Type of property (commercial real property versus a residential condominium versus personal property, for example);
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Number of properties rented;
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Day-to-day involvement of the owner or his agent;
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Type of rental (for example, a net lease versus a traditional lease, short-term versus long-term lease)
See chapter 3.24 – Sec 199A Pass-through Deduction for robust discussion of when a rental constitutes a trade or business.
Caution
The IRS concedes in the preamble to the final regulations that a single rental could require regular and continuous involvement such that the rental activity is a trade or business under Sec 162. But the IRS warns that not every single property rises to the level of a trade or business as a matter of law. In addition, the IRS, in cases where other Code provisions use a trade or business standard that is the same or substantially similar to the Section 162 standard adopted in the final regulations, indicates they will closely scrutinize situations where taxpayers take the position that an activity is a trade or business for purposes of Section 1411, but not a trade or business for such other provisions. For example, if a taxpayer takes the position that a certain rental activity is a trade or business for purposes of Section 1411, the IRS will take into account the facts and circumstances surrounding the taxpayer's determination of a trade or business for other purposes, such as whether the taxpayer complies with any information reporting requirements for the rental activity imposed by section 6041.
Example 1 – Taxpayer rents a single-family residence and just collects a monthly rental check. That may not rise to the level of a trade or business, and if so the rents from that rental are subject to the 3.8% tax. But remember the tax is on the net investment income so you can deduct expenses. But there are court case where such a rental was found to a trade or business – See Chapter 3.24.
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Limited Liability Company (LLC)
It is increasingly common for rental properties to be held in separate LLCs. The proposed regulations require that the determination of whether an activity rises to the level of a trade or business must be done at the entity level.
Example – Jay owns 5 commercial properties through separate LLCs. He also owns two residential rental properties through separate LLCs. The trade or business determination must be made at the entity level, and for Sec 1411 purposes, the fact that Jay qualifies as a real estate professional and has grouped all the properties for purposes of the material participation test has no effect on the determination of whether the entity rises to the level of a trade or business. In Jay’s situation the commercial properties probably meet the trade or business requirement while the two residential rentals may not. Thus, the income from the commercial properties can be excluded from net investment income for purposes of the 3.8% surtax, while the income from the residential rentals may not.
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See further discussion about rentals and the NIIT later in this guide.
Passive Income Vs Trade or Business Income
Making the allocation between passive and trade or business activities in order to avoid the 3.8% tax can have some unexpected ramifications that should be carefully considered. The IRS failed to provide a bright line definition of a trade or business, and is relying on the provisions related to Sec 162 – Trade or Business Expenses.
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Because non-passive income cannot be offset by passive losses, treating profitable rental activities as a trade or business to avoid the tax on investment income will also deny them any offsetting passive losses from other passive rental activities and passive loss carryovers., It might be that passive losses will offset passive income and not create an investment tax problem in the first place.
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But treating rental activities that could be treated as a trade or business as passive in order to net passive gains and losses could have an unintended result when a rental is sold, since the gain from the sale of a passive activity is also subject to the 3.8% tax.