Author: Amanda M. Mills, CPA | Real Estate and Construction Industry Team and Tax Senior Manager
Net investment income (“NII”) under IRC Section 1411 generally includes gross income from rents unless such income is characterized as non-passive and is derived in the ordinary course of a trade or business.
To be “derived in” a trade or business, the preamble of the proposed regulations state that the income must result from an activity that is not passive. The determination of whether the activity is passive is determined at the taxpayer (individual, estate, or trust) level in accordance with IRC Section 469. A brief summary of the rental real estate rules can be found here: https://keitercpa.com/client-alerts/property-owners-benefit-from-classification/.
The rental income must also result in the ordinary course of the taxpayer’s trade or business. Neither IRC Section 1411 nor the proposed regulations provide guidance or define the meaning “ordinary course”. However, other regulation sections and case law are available to help determine whether the rent is derived in the ordinary course of a trade or business.
For NII tax purposes, the proposed regulations incorporate the definition of a trade or business within the meaning of IRC Section 162. The preamble of the proposed rules state that the most established definition of trade or business is found under section162(a), which “permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business”. However, the term “trade or business” is not defined anywhere in the Internal Revenue Code. In the case, Commissioner v. Groetzinger, the Supreme Court examined what is required for an activity to rise to the level of a “trade or business” for tax purposes and determined that no specific test is available. Instead, the decision can only be made by examining the facts on a case-by-case basis and looking into whether the taxpayer devoted his or her full-time efforts towards the activity on a regular, continuous, and substantial basis.
For example, rental real estate subject to a triple net lease would not qualify as a trade or business since the lessor of such lease is not obligated to maintain and operate the property; therefore, he would not meet the requirement of regular and continuous. There is also some controversy when management or rental activities are performed by an agent or an independent contractor or if the taxpayer is merely a limited partner in a rental real estate business. The cases involving these debates have held that the taxpayer is engaged in a trade or business if the activities performed by the agent would, if conducted by the taxpayer, constitute a trade or business.
Other authorities and court decisions have also attempted to define a trade or business under IRC Section 162 by focusing on the taxpayer’s intention to make a profit. For reference, a brief list of factors that should be considered in establishing the existence of a profit motive is included on page 3. Although answering “yes” to any of these questions tends to indicate a profit motive, the list is not all-inclusive and no single factor is determinative.
The chart below outlines the different treatment of passive and non-passive rental real estate as it relates to a trade or business defined by IRC Section 162.
Business Under Section 162
|NOT a Trade or Business Under Section 162|
|Exclude from NII||Include in NII|
|Passive Rental Real
|Include in NII||Include in NII|
It is important to note that income and gains from a non-passive section 162 rental real estate business escapes the NII tax; however, losses from the activity are also excluded from NII and cannot be used to offset rental income from other sources for NII tax purposes. On the other hand, non-passive or passive rental real estate activities that do not constitute a trade or business under section 162 will be included in NII and any rental losses can be used to offset income from other sources in calculating NII.
In order for rental income to be excluded from NII, the income must meet the requirements set forth above; otherwise, the rents could be subject to the 3.8% surtax.
Should you have any questions related to this topic, feel free to contact your Keiter professional or our real estate and construction industry team for further clarification.