Net Gain Attributable to the Disposition of Property
Gains from the sale of property are covered separately under Reg. Section 1.1411-4(a)(1)(iii). Included in this category of income are long-term and short-term capital gain, Section 1231 gain, Section 1245 ordinary income recapture, and unrecaptured Section 1250 gain. Exempt from this category of income are gains derived from a trade or business.
Capital Gains
The final regulations allow the net Schedule D loss up to the amount of the $3,000 ($1,500) loss limitation to be deductible against NII. This includes losses incurred before the imposition of the NIIT (carryover losses). Except, losses attributable to a trade or business are not subject to the NIIT.
Because Sec. 1411(c)(1)(A)(iii) uses the term net gain (which contemplates a positive number), the regulations provide that the amount of net gain included in net investment income may not be less than zero. Although capital losses in excess of capital gains are not recognized for purposes of Sec. 1411, losses allowable under Sec. 1211(b)(1) and (2) are permitted to offset gain from the disposition of assets other than capital assets that are subject to Sec. 1411. (Sections 1211(b)(1) and (2) cover the annual loss limit deduction and carryover.)
Example 1 – Fred has wages of $300,000, earned $5,000 of interest income and has a capital loss of $40,000 from the sale of XYZ stock and a capital gain of $10,000 from selling ABC stock. For regular tax purposes Fred has a capital loss of $30,000, of which he can deduct $3,000 against his other income and carry over the remaining $27,000 to future years. For purposes of Sec. 1411, his $10,000 capital gain is reduced by the $40,000 capital loss, so his net gain is zero. He may reduce the $5,000 investment income by the $3,000 of excess capital losses over capital gains and has a capital loss carryover of $27,000.
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Example 2 – In Year 2, Fred has a $30,000 capital gain on the sale of PDQ stock. For income tax purposes, Fred can reduce the $30,000 gain by the Year 1 $27,000 capital loss carryover. For the Sec. 1411 surtax purposes, Fred's $30,000 gain may also be reduced by the $27,000 capital loss carryover from Year 1. Therefore, in Year 2, Fred has $3,000 net gain for both regular tax and the 3.8% surtax.
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Capital Loss Carryover
Can be used in subsequent years to offset gain and where applicable create an up to $3,000 ($1,500) loss that can be deducted against NII. Except, losses attributable to a trade or business not subject to the NIIT can’t be used. Thus, every year, whether or not the taxpayer is subject to the NIIT, the capital loss carryover will have to be divided and split between carryover that can be used against NII and that which cannot. This requires the additional computation annually.
Impact of Home Sales
Where there is a home sale gain, after taking the Sec 121 exclusion, the remaining gain is reported on Form 8949 (Schedule D) and will end up in the computation for net investment income. As a result, in cases where there is a taxable home sale gain and the taxpayer’s MAGI exceeds the threshold amount, then some or all of the taxable home sale gain profit could be subject to this surtax. On the other hand, the entire gain from the sale of a second home or one held strictly for investment purposes would be included in the investment income computation.
Example - Jay & Emily sell their home that they have owned and lived in for 35 years for $900,000 (net of selling expenses). Their basis in the home is $200,000. Their gain from the sale is $700,000 and they are able to exclude $500,000 under Sec 121. That leaves them with a $200,000 taxable gain that will also be included in the computation of the net investment income for purposes of the 3.8% surtax.
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Exclusion for Certain Gains
Gain from the sale of property will not be included in net investment income, if:
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The property was held in a “trade or business”,
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The trade or business is not the trade or business of trading in financial instruments, and
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The trade or business is not passive to the taxpayer.
This exclusion has a dramatic effect on the owners of sole proprietorships, S corporations, or partnerships, as it may serve to remove a wide array of gains that otherwise would be included within net investment income.
Example - A owns 100% of S Co., an S corporation. S Co. is engaged in a trade or business that is not the trading of financial instruments, and A materially participates in the business. S Co. sells an asset used in its business, generating a $20,000 Section 1231 gain that is allocated to A on his Schedule K-1. Because the $20,000 gain allocated to A was held in a trade or business, the trade or business was not the trading of financial instruments or commodities, and the activity is not passive to A, A may exclude the $20,000 gain from his net investment income computation and NIIT.
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Intangibles and Goodwill
The regulations make it clear that this exclusion includes the gain from the sale of intangible assets, such as self-created goodwill, provided the goodwill was created by a trade or business that is neither the trading of financial instruments nor passive to the taxpayer. The 2013 Prop. Reg. Section 1.1411-4 contains information related to goodwill and partnership distributions. This issue was “reserved” in the final regulations.
Installment Sales
Gain deferred under the Sec 453 installment sale rules is not subject to the surtax in the year of the sale.
Tax Deferred Exchanges
Gain deferred under Sec 1031 is not subject to the surtax to the extent it is deferred into another property.
Rentals & NIIT
The intent behind the 3.8-percent net investment income tax (NIIT) was principally to impose a surtax on unearned, passive-type income. However, the statutory language and lengthy regulations have unfortunately turned this straightforward goal into a complex maze of layered rules. Among the areas of particular concern that have developed has been the determination of when rental income is subject to the NIIT. Unfortunately, the final regulations did not provide a definitive bright line solution. This means we have to navigate some very complex rules that in some cases will require you to make judgment calls.
The basic rule is:
To be exempt from the 3.8% NII tax the rental activity must rise to the level of a trade or business and cannot be passive.
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Rental Income in Trade or Business - Determining whether rental income or gain is derived in the ordinary course of a trade or business is a key element in determining whether rental income is subject to NIIT. If rental income or gain is not derived in the ordinary course of a trade or business, it is NII irrespective of the passive activity of the taxpayer.
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Direct case law or inferred guidance on the issue of what constitutes a trade or business within the context of rental real estate for NIIT purposes is vague at best. Field Service Advice Memorandum 200120036, in connection with an earned income credit issue, noted that, “Where it is clear from the facts that real estate is devoted to rental purposes, the courts have repeatedly held that such use constitutes use of property in a trade or business, regardless of whether or not it is the only property so used.”
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In contrast, however, Example 1 of final Reg. §1.1411-5(b)(2) presents a rental activity of a single commercial building that does not involve the conduct of a trade or business under Code Sec. 162. However, case law holds that the rental of a single property may constitute a trade or business under various provisions of the Code. The IRS is clearly taking the position that the facts and circumstances of each situation will determine if the rental activity rises to the level of a trade or business. As discussed previously whether a rental is a trade or business is discussed in chapter 3.34 – Sec 199A Deduction. It would seem that the Sec 199A treatment of a rental would need to be consistent with the NII treatment.
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Rental Income and Passive Activity Rules - With respect to rental income and its exposure to the NIIT by way of the passive activity loss (PAL) rules, two tests have been suggested:
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If the rents are not derived in the ordinary course of a trade or business, then the rents constitute NII (under Reg. Section 1.1411-4(a)(1)(i)). Whether rents are derived in the ordinary course of a trade or business should be determined under applicable authority, including case law interpreting Code Sec. 162 – Trade or business expenses. (Why Sec. 162? According to the preamble of the Dec. 2012 proposed regulations, “the most established definition of trade or business is found under section 162(a), which permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business.” Thus, to facilitate administration of Sec. 1411, the regulations refer to Sec. 162 for purposes of determining whether an activity is a trade or business for Sec. 1411.)
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If the rents are derived in the ordinary course of a trade or business, then the rents constitute income from a passive activity included in NII unless Code Sec. 469 – Passive Activity Losses – excludes the rents from passive income.,
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Code Sec. 469(c)(2) and (4) lay down the general rule that passive activity includes any rental activity without regard to whether the taxpayer materially participates in the activity. Code Sec. 469(c)(7) carves out exceptions to this general rule for real estate professionals.
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Single Rental - 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.,
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Consistent Treatment – From the Regulations’ preamble - 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 these final regulations, the IRS 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.
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Self-Rented Property Recharacterization - The self-rented property rule under Reg. §1.469-2(f)(6) recharacterizes from passive to non-passive a taxpayer's income from renting property to a trade or business activity in which the taxpayer materially participates. Under the self-rented rule, the taxpayer’s net rental income from the rental of property for use in a trade or business in which the taxpayer materially participates is treated as not from a passive activity. How should this income be treated for the NIIT?
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The final regulations provide that in the case of rental income that is treated as non-passive by reason of Reg. §1.469-2(f)(6), or because the rental activity is properly grouped with a trade or business activity under §1.469-4(d)(1) and the grouped activity is a non-passive activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Thus, that rental income would escape the NIIT. Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as non-passive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a non-passive trade or business.
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Developer’s Recharacterization - The developer rule under Reg. §1.469-2(f)(5) similarly recharacterizes from passive to non-passive a taxpayer’s gain from disposing of rented property if the taxpayer had materially or significantly participated in the trade or business activity of developing the property. If the taxpayer sold the property within 12 months after rental commenced, the gain is generally non-passive. §1.1411-5(b)(2) of the final regulations provides that, to the extent that income or gain from a trade or business is subject to a net income recharacterization rule described in §1.469-2(f)(5), the gross income or gain treated as “not from a passive activity” will be considered derived from a trade or business for purposes of the net investment income tax.
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Real Estate Professionals Exception – A safe harbor test applies for a real estate professional (within the meaning of Sec. 469(c)(7)) who participates in one or more rental real estate activities for more than 500 hours per year (or 500 hours per year in 5 of the prior 10 years). In such cases, the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business, and not subject to the NIIT. Any “grouping” election (under §1.469-9) to aggregate all of a taxpayer’s rental activities is respected for this 500-hour test. (Reg. 1.1411(4)(g)(7))