Final Net Investment Income Tax Regulations and Self-Rented Property

By Betsy Glaeser | Tax Senior Associate

On November 26, 2013, the Internal Revenue Service released the much anticipated final regulations under Section 1411 of the Internal Revenue Code, which provide guidance on the general application of the Net Investment Income Tax (“NII Tax”) and the computation of Net Investment Income.  The newly issued final regulations are generally scheduled to become effective January 1, 2014.  The IRS also issued new proposed regulations addressing topics not originally covered in the November 2012 proposed regulations. The scope of this discussion relates to the final regulations and the self-rented property provision.

Self-rented property is defined under Internal Revenue Code Section 469. A self-rented scenario generally involves property rented by a taxpayer to a trade or business activity in which the taxpayer materially participates. Affectionately called the “heads I win, tails you lose” rule, income from a rental activity is generally recharacterized as nonpassive where the property is rented to an activity in which the owner of the property is rented to an activity in which the owner of the property materially participates; however, loss generated by a self-rented property is not recharacterized as nonpassive (Reg. Section 1.469-2(f)(6)). Given that passive losses can only be used to offset passive income, this rule can limit the use of self-rented losses for many taxpayers.

Because of this rule, some taxpayers will “group”, when grouping is available, a self-rental activity with a trade or business in which the real estate owner is a material participant. To be grouped as a single activity, the activities must constitute an appropriate economic unit (“AEU”) (Reg. Section 1.469-4(c)(2)). Whether activities constitute an AEU depends upon all the relevant facts and circumstances. A few items commonly weighed in determining whether activities constitute an AEU include: similarities and differences in types of trades or business, the extent of common control, the extent of common ownership, geographical locations, and interdependencies between or among the activities. However, Reg. Section 1.469-4(d)(1) contains a limitation on the grouping of rental activities with trade or business activities.

A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit under paragraph (c) of this section – and (1) the rental activity is insubstantial in relation to the trade or business activity; (2) The trade or business activity is insubstantial in relation to the rental activity; or (3) Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

The 3.8% NII Tax imposed by Section 1411 became law as part of the 2010 Health Care Act, and became effective January 1, 2013. The tax is imposed on the lesser of an individual’s (i) net investment income or (ii)modified adjusted gross income in excess of $200,000 ($250,000 for married filing jointly taxpayers). Net investment income falls into three Buckets:]

Bucket #1 – Interest, dividends, annuities, royalties and rents, unless any of the foregoing items are derived in a trade or business.

Bucket #2 – Gross income from a passive activity (as defined under section 469) or the trade or business of trading in financial instruments or commodities (either, a “Covered Trade or Business”).

Bucket #3 – Net gain from the disposition of property, other than property held in a trade or business that is not a Covered Trade or Business (i.e. Bucket #2).

The items of income or gain listed above are then reduced by properly allocable deductions. Also, the NII Tax is not imposed on any income that constitutes self-employment income.

While the proposed regulations were unclear about the treatment under Section 1411, the final regulations have clarified the treatment of certain nonpassive rental activities. In the case of rental income that is treated as nonpassive by reason of Reg. Section 1.469-2(f)(6) (the “heads I win, tails you lose” rule described above) or because the rental activity is properly grouped with a trade or business activity under Reg. Section 1.469-4(d)(1) and the grouped activity is a nonpassive activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. This clarification means that the income avoids the NII tax under Bucket #1 and Bucket #2 because the rental income from the activity is considered to be nonpassive. Additionally, the final regulations provide that any gain or loss from the assets associated with the rental activity that is treated as nonpassive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a nonpassive trade of business, and therefore, avoids the NII Tax.

Generally, under Section 469, after a taxpayer has grouped activities, the taxpayer may not regroup those activities in subsequent taxable years. However, the final regulations allow the taxpayer to regroup activities under Reg. Section 1.469-11(b)(3)(iv). Under this provision, regrouping may occur only during the first taxable year beginning after December 31, 2012, in which (1) the taxpayer meets the applicable income threshold under Section 1411, and (2) has net investment income. The final regulations also allow a taxpayer to regroup on the amended return; but only if the taxpayer was not subject to Section 1411 on his or her original return (or previously amended return), and if, because of a change to the original return, the taxpayer owed tax under Section 1411 for that taxable year. This rule also applies to changes to modified adjusted gross income or net investment income upon an IRS examination.

While the final regulations, as well as the new proposed regulations, made significant progress in clarifying the new law, Section 1411 still remains a complex area and can be difficult to navigate. Please contact your Keiter CPA to further discuss how the NII Tax may affect you at 804.747.0000 | information@keitercpa.com.