Thankfully, the IRS responded positively to our concerns and now provides a safe-harbor rule for qualified real

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1 SUMMARY OF SELECTED PROVISIONS OF 3.8% NET INVESTMENT INCOME TAX FINAL & PROPOSED REGULATIONS (Final 1411 Regulations [TD 9644] AND 2013 PROPOSED REG ). Background. On December 5, 2012, the IRS released Proposed Regulations though providing extensive guidance regarding the new 3.8% tax on investment income (the 2012 Proposed Regulations.). These proposed regulations are reliance regulations and therefore may be relied upon for the 2013 tax year. On November 25, 2013, the IRS issued the final section 1411 regulations. These final regulations are generally effective for tax years beginning after However, taxpayers may elect to apply the final regulations for tax years beginning after 2012 (the effective date of 1411 and the 3.8% net investment income tax). Therefore, for tax years beginning in 2013, taxpayers my apply either the proposed regulations issued on December 5, 2012 or the final regulations issued on November 25, 2013 (Final Regulation (f) and (g)). In addition, on November 25, 2013, the IRS also released new 2013 proposed regulations [REG ] (the 2013 Proposed regulations ). These regulations are proposed to be effective for tax years beginning after 2013, and address issues not covered in the final regulations for which the IRS believes an additional comment period is necessary. In both the 2013 Individual Tax and the 2013 Federal Tax Update manuscripts we summarized the 2012 proposed regulations in some detail. Although the final regulations largely follow the general operating provisions of the 2012 proposed regulations, the final regulations do contain a series of critically important changes. Therefore, summarized below are selected changes made to the 2012 proposed regulations by the final regulations (and by the new 2013 proposed regulations) that we believe will have the greatest impact on taxpayers and practitioners. 1. Qualified Real Estate Professional Safe-Harbor. Under 1411, rental income is investment income potentially subject to the 3.8% Net Investment Income Tax (NIIT), unless the rentals are received in the ordinary course of a trade or business that is not a passive trade or business activity under 469. The preamble to the 2012 proposed regulations indicated that, even if real estate rental income is not passive income under 469 because the taxpayer is a qualified real estate professional (under 469(c)(7)) and materially participates in the rental real estate activity, all rental activities (even when conducted by a qualified real estate professional) do not necessarily constitute a 162 trade or business as defined by case law. Many of us suggested to the IRS National Office that this would create substantial controversy, and we requested that the final regulations provide additional guidance as to whether rental income received by qualified real estate professionals would be subject to the NIIT. Thankfully, the IRS responded positively to our concerns and now provides a safe-harbor rule for qualified real estate professionals in the final regulations. Final regulation (g)(7)(i) says that rentals received by a qualified real estate professional (QREP) from a rental real estate activity will be deemed to be received in a 162 trade or business if the QREP: 1) participates more than 500 hours in the rental real estate activity during the current year, or 2) participated more than 500 hours in such rental real estate activity in any 5 out of the 10 years preceding the current year. Final regulation (g)(7)(i)(B) also provides that any gain from the disposition of assets associated with a QREP s rental real estate activity qualifying under this safe harbor will be treated as gain from a nonpassive trade or business activity. Therefore, such rental income or gain should not be investment income and should not be subject to the 3.8% NIIT. Practice Alert! Unless a taxpayer has made the aggregation election provided by regulation (g), each rental property is a separate activity for purposes of the 500 hour test. Therefore, taxpayers with several rental properties may need to make the aggregation election to treat all of their rental properties as one activity in order to pass the 500 hour test. Practice Pointer! Once made, the aggregation election is binding for future years unless there is a material change in the taxpayer s facts and circumstances. Please Note! A QREP who fails to satisfy the requirements of this safe harbor would have to rely on the common law facts and circumstances test to determine whether the rental real estate activity constitutes a trade or business under section 162 (See final 1

2 regulation (g)(7)(iii)). 2. Safe Harbor For Self Rentals. Regulation (f)(6) provides that rental income received by a taxpayer is not passive income if the income is received from property rented to an activity in which the taxpayer materially participates (self-rentals). Therefore, this self-rental income is not passive income. However, the preamble to the 2012 proposed regulations and IRS officials indicated that it might be difficult for a taxpayer to show that such rentals are 162 trade or business rentals and, therefore, self-rental income may be investment income subject to the 3.8% NIIT even though self-rental income is not passive income. However, final regulation (g)(6)(i) provides that rental income from property rented to an activity in which the taxpayer materially participates (i.e., self rentals described under regulation (f)(6)(ii)) will be deemed to be 162 trade or business income. Therefore, rental income from property rented to an activity in which a taxpayer materially participates should not be investment income and should be exempt from the 3.8% NIIT. This is a major change from the position taken by the IRS in the 2012 proposed regulations. Practice Pointer! Final regulation (g)(6)(ii) also provides that any gain from the disposition of assets associated with the nonpassive self-rental will be treated as gain from a nonpassive trade or business activity and, therefore, should also be exempt from the 3.8% NIIT. 3. Grouping Safe Harbor. Regulation (d)(1) allows a rental activity to be grouped with a nonrental activity if the rental activity and the nonrental activity constitute an appropriate economic unit as defined under the regulations and either: 1) the rental activity is incidental to the nonrental activity or 2) the same taxpayers own the rental activity and the nonrental activity in the same proportion and the rental property is rented to the trade or business activity. Final regulation (g)(6)(i) provides that if a rental activity is grouped with a nonrental activity under regulation (d)(1) and the resulting grouped activity is not passive (e.g., the taxpayer materially participates in the grouped activity), then the rental income will be deemed to be received in the ordinary course of a 162 trade or business activity. Practice Pointer! In addition, this final regulation provides that to the extent gain from the disposition of property is treated as nonpassive as a consequence of the grouping, such gain is deemed to be derived from a nonpassive trade or business. Thus, the income or gains from this grouped rental activity should not be subject to the 3.8% NIIT. 4. Certain Losses From Investment Assets Allowed To Offset Investment Income. The 2012 proposed regulations generally provide that net gains from the disposition of property are investment income, unless the gain is from property used in a nonpassive trade or business which is not a business of trading financial instruments or commodities. The proposed regulations did not allow losses from the disposition of property in excess of gains to be deducted in calculating the NIIT. However, final regulation (f)(4) provides that losses in excess of gains may be treated as allocable deductions and reduce other investment income (e.g., interest, dividends, royalties) in calculating NIIT, if such losses are deductible on the taxpayer s income tax return for the year under 165. For example, assume an individual has $20,000 of capital gains for 2013 and $40,000 of capital losses. The 2012 proposed regulations only allowed $20,000 of the $40,000 of capital losses to offset the $20,000 of capital gains in calculating the NIIT, even though the individual could deduct another $3,000 of the losses on the individual s 1040 return. Final regulation (f)(4) now allows the individual to reduce other investment income by the $3,000 capital loss deduction allowed on Form 1040 in calculating the NIIT. In addition, final regulation (f)(4) provides that if a trader in financial instruments or commodities has made the mark-to-market election under 475(f), any losses from such trading activities in excess of 1) gains for the year from such trading activities and 2) any other gains included in investment income, are allocable deductions and may reduce other investment income in calculating the NIIT. 5. Deductions That May Reduce Investment Income. Under the 2012 proposed and the 2013 final regulations, deductions that may reduce gross investment income in calculating the 3.8% NIIT are called allocable deductions. The final regulations, however, list several additional allocable deductions that may be used to reduce investment income. These deductions that were not mentioned in the 2012 proposed regulations include: 1) The following expenses to the extent allocable to investment income: a) Expenses paid in determining a taxpayer s tax liability under 212(3) (e.g., return preparation fees), b) deductions in respect of 2

3 a decedent under 691(c), and c) fiduciary expenses (as described in regulation (i)) of an estate or trust; and 2) Amortizable bond premium. In addition, the final regulations clarify that the deductions allocable to investment income include those allowed for regular tax purposes even where the taxpayer is subject to the AMT. For example, state income taxes allocable to investment income are deductible in calculating net investment income even where the taxpayer is subject to the AMT. 6. Net Operating Loss Carryovers And Carrybacks. The 2012 proposed regulations did not allow any portion of an NOL carryover or carryback to reduce investment income in arriving at net investment income for purposes of the NIIT. However, final regulation (h) provides that the applicable portion of a net operating loss may be deducted in calculating the NIIT in a year to which the loss is carried. The applicable portion is generally the lesser of: 1) the amount of the net operating loss the taxpayer would have incurred for the loss year if only items of gross investment income under 1411 and deductions allocable to investment income are taken into account in determining the NOL; or 2) the amount of the actual NOL for the year. Final regulation (h)(5) contains two detailed examples for calculating the applicable portion of an NOL that may be deducted in a carryover or carryback year in calculating the NIIT. 7. 2% And 3% Subtraction Rules. Both the 2012 proposed regulations and the final regulations provide that the itemized deductions allocable to investment income that are deductible in determining net investment income are the deductions allowed on Form 1040 after applying any required 2% subtraction under 67 and any required 3% subtraction under 68. Under the 2012 proposed regulations, the amount of the itemized deductions disallowed by the 2% or 3% reduction rule were deemed to consist of a pro rata portion of the itemized deductions allocable to investment income and the itemized deductions not allocable to investment income. However, the final regulations assume that the itemized deductions that are not allocable to investment income are reduced by the 2% and 3% subtraction first. For example, assume that Tim s total itemized deductions subject to the 3% of AGI reduction rule under 68 for 2013 is $50,000 and that $10,000 of the $50,000 of deductions is allocable to investment income. Also assume that Tim s $50,000 of itemized deductions is reduced by $12,000 because of the 3% subtraction under 68 and, therefore, $38,000 of the $50,000 amount is actually allowed as an itemized deduction for the year on Schedule A of Form Final regulation (f)(7) provides that the amount of investment expenses subject to the 3% reduction rule for 2013 allowed to reduce investment income (i.e., allocable deductions) is the lesser of: 1) the itemized deductions allocable to investment income before the 3% reduction ($10,000) or 2) the total itemized deductions subject to the 3% reduction rule allowed after the 3% subtraction ($38,000). Therefore, Tim may deduct $10,000 of the itemized deductions subject to the 3% reduction in calculating his 2013 net investment income. 8. Self-Charged Interest Rules For Loans To Passthrough Entities. Final regulation (g)(5) provides a special rule that addresses self-charged interest. The special rule provides that, in the case of self-charged interest received from a nonpassive passthrough entity, the amount of interest income excluded from net investment income will be the taxpayer's allocable share of the nonpassive deduction. The rule cross-references the self charged interest rule of regulation for the operative mechanics. The mathematical result of this special rule is to exclude an amount of interest income from net investment income that is equal to the amount of interest income that would have been considered passive income under regulation if the nonpassive activity were considered passive activity. However, the special rule contains an exception. The special rule will not apply to a situation where the interest deduction is taken into account in determining self-employment income that is subject to tax under section 1401(b). Please see Regulation for the mechanics of this rule. 9. Dividends, Interest, Royalties, Etc. Generated In The Ordinary Course Of A Trade Or Business. Generally, gross income from interest, dividends, annuities, and royalties is "investment income" subject to the 3.8% NIIT. However, interest, dividend, annuity, and royalty income will not be "investment income" if the income is derived in the ordinary course of a trade or business which is neither 1) a "passive activity" under 3

4 469, or 2) a business that "trades in financial instruments or commodities ( 1411(c)(1)(A)(i)). The preamble to the final section 1411 regulations generally states that interest, dividends, royalties, or annuities will be deemed to be derived in the ordinary course of a trade or business if such income falls within one of the situations in regulation T(c)(3)(ii). See also final regulation (a). For example, regulation T(c)(3)(ii) provides that interest income is deemed derived in the ordinary course of a trade or business if the interest comes from: 1) loans and investments made in the ordinary course of a trade or business of lending money; or 2) accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business. In addition, regulation T(c)(3)(ii)(E) provides that royalty income shall be considered to be derived in the ordinary course of a trade or business if the royalties are derived in the ordinary course of a trade or business of licensing intangible property. Regulation T(c)(3)(iii)(B) provides that royalties are considered to be derived by a person in the ordinary course of the trade or business of licensing intangible property only if such person: 1) created such property; or 2) performed substantial services or incurred substantial costs (as defined in regulation T(c)(3)(iii)(B)(2)) with respect to the development or marketing of such property. 10. Losses And Deductions Allowed Beneficiary Of Estate Or Trust Under 642(h). Section 642(h)(1) provides that if upon the termination of an estate or trust, the estate or trust has a net operating loss carryover under 172 or a capital loss carryover under 1212, the remaining net operating loss carryover or capital loss carryover is allowed to the beneficiaries succeeding to the property of the estate or trust. In addition, 642(h)(2) generally provides that the excess of deductions over income for the final year of the estate or trust may be allowed as a deduction to the beneficiaries succeeding to the property of the estate or trust. Final regulation (g)(4) provides that these deductions allowed under 642(h) to a beneficiary of an estate or trust may be deducted by the beneficiary in calculating the beneficiary s net investment income to the extent the deductions would have been allocable deductions to the estate or trust under final regulation (f). In addition, the amount of these items that the beneficiary may take into account in determining the beneficiary s net investment income is limited to the amount of the estate or trust s negative investment income upon termination. 11. Deductions In Respect Of A Decedent Under 691(b). Section 691(b) provides that an estate (or successor to property) may take deductions described in section 162, 163, 164, 212, or 611 in respect of a decedent, which are not properly allowable to the decedent. These items are often referred to as Deductions in Respect of a Decedent, or DRD. Regulation (g)(3) provides a special rule that allows for deductions described in section 691(b) to be claimed by an estate in calculating net investment income to the extent the DRD would have been an allocable deduction under regulation (f) to the decedent. For example, an estate may deduct the decedent s unpaid investment interest expense in computing its net investment income. 12. Deductions For Estate And Generation-Skipping Taxes Allowed By 691(c). Section 691(c) allows a deduction for estate and generation-skipping taxes allocable to income in respect of a decedent when that income is reported by an heir to the estate of a decedent. Regulation (f)(3)(v) provides that deductions for estate and generation-skipping taxes allowed by 691(c) that are allocable to net investment income reduce net investment income subject to the NIIT. 13. Deduction For Otherwise Suspended Passive Activity Losses Allowed Upon Disposition Of Entire Activity. Section 469(g) provides that otherwise suspended losses from passive activities are allowed in full if the taxpayer s entire interest in the activity is disposed of in a fully taxable disposition. Regulation (g)(9) provides that these losses will be allowed as a deduction in calculating net investment income in the same manner they are taken into account for income tax purposes. 14. State Income Tax Refunds. Final regulation (g)(2) provides that state income tax refunds must reduce allocable deductions for the year of the refund to the extent the state income taxes reduced net investment income in a prior year. This rule applies regardless of whether the amount of the recovery is 4

5 otherwise excluded from income by reason of section 111 (Regulation (g)(2)(i)). Practice Alert! No reduction in allocable deductions is required for the year of the refund unless the taxes refunded actually reduced the taxpayer s net investment income tax for the prior year. For example, a state income tax refund received in 2013 for a 2012 overpayment would not reduce 2013 allocable deductions because the NIIT did not apply for This rule also applies to the recovery of other items that were deductible in a prior year in determining net investment income. 15. Charitable Remainder Trusts. Solely for purposes of 1411, the 2012 proposed regulations provide a simplified method for a charitable remainder trust (CRT) to track net investment income received after December 31, 2012, and later distributed to the beneficiary. Under this simplified method, the 2012 proposed regulations provide that distributions from a CRT to a beneficiary for a taxable year consist of net investment income in an amount equal to the lesser of: 1) the total amount of the distributions for that year, or 2) the current and accumulated net investment income of the CRT (2012 proposed regulation (c)(2)(i)). However, final regulation (d)(2) replaces the simplified method for tracking distributions of investment income under the 2012 proposed regulations with the existing income category and class system under 664, as described in regulation (d)(1)(i)(b). Both the proposed and the final regulations contain the rule that net investment income accumulated in the CRT prior to 2013 will not be subject to the 3.8% NIIT if and when it is distributed to the beneficiary. Practice Alert! The new 2013 proposed regulations generally allow a CRT to make an irrevocable election to use either the simplified method included in the 2012 proposed regulations (as modified by the 2013 proposed regulations) or the income category and class system under 664 as provided by the final regulations in determining the portion of a distribution from a CRT that is investment income. Please see the preamble to the 2013 proposed regulations (REG ) and 2013 proposed regulation (d)(3) for details concerning the election to use the simplified method. 16. Gain Or Loss From Disposition Of S Corp Stock Or Partnership Interest. Section 1411(c)(1)(a)(iii) says that investment income includes net gain attributable to the disposition of property. However, 1411(c)(4) generally provides that gain or loss from the disposition of S corporation stock or a partnership interest is included in calculating investment income of the S corp shareholder or partner only to the extent a deemed sale of the entity s assets would have produced gain or loss allocable to the shareholder or partner that is taken into account in determining the shareholder or partner s investment income. Generally, 2012 proposed regulation calculated the amount of the gain from the disposition of S corp stock or a partnership interest that was subject to the NIIT by reducing the gain on the disposition of the S corp stock or the partnership interest by the gain allocable to the nonpassive trade or business assets of the entity upon a deemed sale of the assets. This calculation required the transferor to determine the adjusted basis and the value all the trade or business assets of the entity in order to compute the portion of the gain from the disposition of the stock or partnership interest that would have been investment income upon a deemed sale of the entity s assets. On November 25, 2013, the IRS withdrew 2012" proposed regulation , and replaced it with new 2013 proposed regulation New 2013 proposed regulation takes a different approach by including gain or loss from the disposition of S corp stock or a partnership interest in the calculation of investment income to the extent gain or loss from a deemed sale of the entity s assets would be taken into account in determining investment income under Practice Alert! 2013 proposed regulation (a)(3) provides that the entire gain or loss from the disposition of S corp stock or a partnership interest will be taken into account in calculating investment income unless: 1) the passthrough entity is engaged in one or more trades or business (other than the trading in financial instruments or commodities), and 2) one or more of these trades or businesses is not a 469 passive activity of the transferor. However, if the transferor materially participates in one or more of the S corp or partnership s trades or businesses (other than a trade or business of trading in financial instruments or commodities), then, 2013 proposed regulation is used to determine the amount of the gain or loss from the disposition of the S corp stock or the partnership interest that is taken into account in calculating investment income for purposes of the NIIT. Under 2013 proposed regulation , the transferring partner or S corporation shareholder computes 5

6 the portion of the overall gain or loss from the sale of the S stock or the partnership interest taken into account in calculating investment income for purposes of the 3.8% NIIT by applying either the primary method, or the optional simplified method. a. Primary Method. The primary method provides that the amount of the gain or loss upon the disposition of S corp stock or a partnership interest that is taken into account in calculating the 3.8% NIIT is the lesser of: 1) the transferor s total recognized gain or loss on the disposition of the interest in the passthrough entity, or 2) the transferor s allocable share of the net gain or loss from a hypothetical deemed sale of the entity s Section 1411 Property (2013 proposed regulation (b)(1)(i)). Section 1411 Property is property held by the passthrough entity that, if sold by the entity, would result in a net gain or loss includable in the S corp shareholder s or the partner s calculation of net investment income under 1411 (2013 proposed regulation (a)(2)(iv)). Practice Alert! Where there is a loss on the disposition, the loss amounts at item 1) and at item 2) above are expressed as positive numbers to determine whether item 1) or 2) is the lesser amount. b. Optional Simplified Method. Generally, the transferor of an interest in a pass-through entity may use this optional simplified method if the transferor meets either of the following eligibility requirements: 1) the total amount of gain or loss recognized by the transferor does not exceed $250,000; or 2) the transferor meets both of the following conditions: a) the overall gain or loss does not exceed $5 million, and b) during the Section 1411 Holding Period (generally the year of transfer and the two previous years), the sum of the transferor s separately stated items of income, gain, loss and deduction (treating loss and deduction items as positive numbers) that the transferor would take into account in calculating the 3.8% NIIT is 5% or less of the sum of all separately stated items of income, gain, loss, and deduction (treating loss and deduction items as positive numbers) allocated to the transferor during the Section 1411 Holding Period. If the transferor qualifies and chooses to use this simplified formula, the percentage of the overall gain on the disposition of the S corp stock or the partnership interest taken into account in calculating investment income is generally the same percentage of the transferor s allocable share of the passthrough investment income during the previous Section 1411 Holding Period (generally the year of transfer and the two previous years) as compared to the seller s allocable share of total pass-through income during that same period. For example, if ten percent of the income reported on the applicable Schedules K-1 is of a type that would be included in net investment income, then the simplified reporting method presumes that ten percent of the total gain from the disposition of the S corp stock or partnership interest is taken into account in calculating the transferor s investment income. Practice Alert! Proposed regulation (c)(3) lists certain situations where an otherwise qualifying transferor will not be allowed to use this simplified computational formula (e.g., the transferor has held the interest for less than 12 months; certain contributions and/or distributions were made with respect to the pass through-entity during the Section 1411 Holding Period; the entity is an S corporation, was previously a C corporation, and the S election was made during the Section 1411 Holding Period. ). END 6