PAL and Section 1411

PAL and Section 1411 By Thomas C. Nice September 23, 2014 The Net Investment Income ( NII ) Tax of IRC Section 1411 applies to real estate income if the income is passive, or not from an IRC Section 162 trade or business. Understanding the Passive Activity Loss rules of IRC Section 469 and the reporting rules of IRC Section 1411 can help advisors structure transactions that utilize passive activity losses and moderate the impact of the NII tax. 2 1

PAL Rules General Rules - Definition of an activity 1. Trade or business activities = activities, other than rental activities, that involve the conduct of a 162 trade or business (Reg. 1.469-4) 2. 1.469-1T(e)(3): Rental activities = if: a. During the taxable year, tangible property held in connection with the activity is used by or available for use by customers, and b. The gross income attributable to the activity represents amounts paid for the use of such tangible property. i. Less certain exceptions such as average period of use of property being 7 days or less, amounts paid are mostly for extraordinary personal services, etc. Definition of passive activity = any activity: Which involves the conduct of any trade or business (See Section162), and In which the taxpayer does not materially participate (IRC Section 469(c)(1). This definition includes any rental activity (IRC Section 469(c)(2)), regardless of whether the taxpayer materially participates in the business (contrast it to the 1411 definition, which we ll see later on, where rental activities are not per se passive if conducted by a RE professional, and thus, may not be subject to the NIIT). 4 2

Effect of finding that an activity is passive May have passive investment losses that are suspended for the taxable year (IRC Section 469(d)) unless you have current income from passive activities as well. Unused losses must be carried forward, and cannot be offset by active income (IRC Section 469 (b)). 5 What activities are NOT passive? Answer: Activities in which the taxpayer materially participates. Material participation test Test = based on all of the facts and circumstances, a taxpayer participates on a regular, continuous, and substantial basis in operations of activity. 6 3

Examples of RCS: Material participation of a taxpayer for any activity is determined separately for each taxable year and the burden of proof is generally on the taxpayer. See Harrison v. Comm r, T.C. Memo. 1996-509. If this standard seems poorly defined, that s because it is. Most case law does not talk about the regular, continuous, and substantial basis standard, preferring to focus on the 7 tests of Treasury Regulation 1.469-5T that prove material participation. However, the RCS standard must be met to ensure that the taxpayer s participation in the activity meets one of the 7 material participation tests of the regulations. 7 Certain work not customarily done by owners is not treated as participation in an activity (1.469-5T(f)(2)(i). September 8, 2014 8 4

The Senate Report discussing the RCS standard provided some qualitative guidelines to determine whether participation is RCS: 1. Is the activity the taxpayer s principal business? 2. Is the taxpayer regularly present at the place where the principal operations of the activity are conducted? a. If yes to those questions, good chance the activity is RCS to the taxpayer. 3.Formal and nominal participation in management is disregarded. 4. The taxpayer s knowledge and experience in the business of the activity are highly significant. 9 Must meet one of 7 tests to prove material participation (but still have to meet RCS standard) (Treas. Reg. 1.469-5T(a)). 1. The taxpayer works 500 hours or more during the year in the activity. 2. The taxpayer does substantially all the work in the activity. 3. The taxpayer works more than 100 hours in the activity during the year and no one works more than the taxpayer. 10 5

However, even if the taxpayer s services exceed that of all other participants, she still must meet the 100-hour threshold under 1.469-5T(a)(3). See Pohaski v. Comm r, T.C. Memo. 1998-17 (taxpayer did not meet 100-hour threshold and, so, did not materially participate). BUT see 1.469-5T(a)(2) if the taxpayer participates fewer than 100 hours, but the taxpayer s activity still constitutes substantially all the work in the activity, should still meet material participation standard. For this test, work performed by non-owners (such as employees or independent contractors) is also considered when determining whether another s services exceeded those of the taxpayer s. 11 Beyond this, it is not entirely clear how a taxpayer should compare his participation to others participation. The IRS has used both quantitative (hours spent (see TAM 9543003) and qualitative tests (a taxpayer s involvement is greater than others or her role is more important to the business), in light of the facts and circumstances see 1.469-5T(b)(2)(ii)(B). However, to the extent a quantitative standard is used, even one extra hour spent by someone else may be fatal. 12 6

Emphasize the importance of contemporaneous recordkeeping cannot prove participation without it (see 1.469-5T(f)(4)). Tax Court, in particular, will not accept post-event ballpark guesstimates [see Wilson v. Comm r, T.C. Memo 2012-101; D Avanzo v. U.S., 67 Fed. Cl. 39 (Fed. Cl. 2005)]. 13 The activity is a significant participation activity (SPA) and the sum of SPAs in which the taxpayer works 100 500 hours exceeds 500 hours for the year. SPA = the activity: Is a trade or business activity in which the individual significantly participates for the taxable year (e.g. more than 100 hours a year)? AND The taxpayer does not materially participate according to any other test in 1.469-5T(a). Rental activities cannot be SPAs (see TC Memo 2002-35). 14 7

5. The taxpayer materially participated in the activity in any 5 of the prior 10 years. 6. The activity is a personal service activity and the taxpayer materially participated in that activity in any of the 3 preceding taxable years. 7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity. No one else works more hours than the taxpayer in the activity and no one else receives compensation for managing the activity. 15 Real Estate Professional Rules Under 469(c)(2), rental real estate activities are deemed to be passive for purposes of the passive activity rules. However, under 469(c)(7), a taxpayer may be a real estate professional if certain requirements are met and 469(c)(2) will not apply. 16 8

Requirements are: More than ½ of the personal services performed in the taxpayer s trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates. AND The taxpayer performs more than 750 hours of services in those real property trades or businesses. 17 Real property trade or business = any development, redevelopment, construction, acquisition, rental, management, leasing of real property (not an exhaustive list). Taxpayer may also elect to treat all interests in rental real estate as one activity under 469(c)(7)(A). Effect the rental real estate activities of the Real Estate professional are treated as non-passive if the Real Estate professional materially participates in that rental real estate activity. 18 9

If not a real estate professional under Section 469(c)(7), no grouping is allowed for taxpayer s rental real estate activities. 19 Making this election makes it easier to meet the material participation requirement. For instance, if a qualifying taxpayer that does not make a 469( c)(7) election participated in 3 separate rental real estate activities for 200 hours in a year, per activity, the activity may be passive with respect to the taxpayer and 1.469-5T(a)(1). Making the election will result in the taxpayer as having participated for 600 hours in the combined rental real estate activity, which exceeds the 500 hours threshold under the material participation of 1.469-5T (a)(1). 20 10

However, it may not be advisable for a taxpayer to make the election if the taxpayer has positive net income from rental real estate activities and passive losses from other non-rental real estate activities. Treating the real estate activities as passive would allow that taxpayer to offset current non-real estate passive losses. The election does not affect the application of the PAL real estate professional test, but the election becomes relevant after a taxpayer is determined to be a real estate professional. See Donald W. Trask, T.C. Memo. 2010-78. 21 Effect: If a taxpayer owns 8 interests in rental real estate, qualifying as a real estate professional, and fails to make said election, the taxpayer will be required to measure materially participation in each of those properties separately. See Karl Jahina, T.C. Summ. Op. 2002-150. 22 11

Remember: Contemporaneous substantiation is your friend make sure you keep a record of the HOURS spent (not just the days) on each activity. See Andre Nelson, T.C. Summ. Op. 2004-62. 23 Active Participation Qualifying Real Estate professionals may deduct up to $25,000 of passive activity losses and credits from rental real estate activities in which the taxpayer actively participates against non-passive income. IRC Section 469(i). 24 12

Active participation is different than material participation. Less stringent standard. Active participation can be satisfied without regular, continuous, and substantial involvement so long as the taxpayer participates in the rental real estate activity. Active participation can be making management decisions in a significant and bona fide sense. Net lease arrangements not sufficient. 25 Active participation also requires that the taxpayer must at all times during the period own at least 10% (by value) of all interests in the activity. IRC Section 469(i)(6). $25,000 offset for rental real estate activities. Individuals are allowed to deduct the first $25,000 of net passive losses from rental real estate activities against their non-passive income if the individuals actively participate in the rental real estate activity under the standard above in the tax year the loss is incurred. (Subject to Phase-Out). Married taxpayers filing separately get $12,500 if the couple lived apart for the entire year. 26 13

The $25,000 allowance is phased out with higher AGIs. The offset is 50% of the amount by which the individual s modified AGI exceeds $100,000. So, if a taxpayer s MAGI increases from $100,000 to $150,000, the $25,000 allowance decreases from $25,000 to 0. 27 Recent developments regarding material participation in re: Material Participation of Trustees Frank Aragona case 142 T.C. 9 This year, the Tax Court determined that a trust that owned real estate properties and engaged in other real estate activities qualified for the 469(c)(7) real estate professional elections. Therefore, services performed by an individual Trustee on behalf of a trust may be considered personal services performed by the trust. The Court found that the Trust did materially participate in its real estate operations, through the activities of its trustees in their roles as trustees and employees. The Court also found that the Trust s real estate operations were substantial and the trustees handled almost no other businesses for the Trust beyond the real estate operations. September 8, 2014 28 14

This case has ramifications for both PALs, as rental activities of trusts need not be treated as per se passive activities, and the NIIT, as fewer trusts may be liable for the NIIT if they are deemed to materially participate in the trust s real estate activities. Contrast this with older authority: Mattie K. Carter Trust 256 F. Supp. 2d 536 (D.C. Tex. 2003) The Court held that a trust s material participation in ranching operations should be determined by reference to the collective activities of the individuals who conducted those ranching operations. This includes both the Trust s trustees, as well as its employees who are not trustees. September 8, 2014 29 TAM 200733023 and 201317010 However, the IRS has refused to follow Mattie K. Carter and the above TAMs hold that whether a trust materially participates in a trade or business is solely dependent on the activities of the trustees in their capacities as trustees. (i.e.; time spent as employees is disregarded.) TAM 200733023 and 201317010 Distinguished the activities of special trustees from fiduciary trustees and only fiduciary trustees activities should be counted when meeting the material participation test. It is unknown how the Service will rule in similar cases after the Frank Aragona ruling. September 8, 2014 30 15

Net Investment Income Tax Rules Section 1411 What is it? For tax years beginning after 12/31/12, certain unearned income of individuals, trusts, and estates is subject to a tax the Net Investment Income Tax (NIIT). September 8, 2014 31 Back to Section 162 income earned in the ordinary course of a trade or business where the taxpayer materially participates is excluded from the NIIT. September 8, 2014 32 16

What is subject to the NIIT? Interest/dividends/rents/royalties/annuities, less allocable deductions. Includes passive shareholders/partners share of business income from pass-throughs. September 8, 2014 33 Who is NOT subject? Shareholders who materially participate in activities of the pass-through are not subject to the NIIT generated from the activities in which they materially participate if the activity is a IRC Section 162 T or B. September 8, 2014 34 17

Material participation If there is material participation in an activity taxpayer may not be subject to NIIT. Interaction with Section 162. September 8, 2014 35 What is a 162 trade or business? Trade or business not actually defined in the Code definition is murky and often based on case law. Continuity and regularity of an activity are important factors, but are not dispositive. Other factors may be: Legitimate profit or gain motive. Taxpayer s expertise in the business. Taxpayer devotes substantial time to the activity. Activity generates significant profits. Activity is a meaningful part of taxpayer s sources of income For Real Estate specifically type of property may be a factor, as well as day-to-day involvement of the owner, the type of rental (net lease vs. traditional lease), and number of properties rented. Generally, trade or business activities that are not rental activities are treated as passive unless the taxpayer materially participates in the activity. September 8, 2014 36 18

For individuals, the surtax is 3.8% of the lesser of: Net investment income, OR The excess of modified adjusted gross income (MAGI) over the threshold amount. September 8, 2014 37 Terminology: Net investment income = sum of three categories of income: Category (i) income: gross income from interest, dividends, annuities, royalties, rents not derived in ordinary course of trade or business (not 162 T or B). Category (ii) income: gross income derived from a passive activity of the taxpayer or income by a financial trader. Category (iii) income: net gain attributable to the disposition of property, other than property held in a passive activity. September 8, 2014 38 19

MAGI = adjusted gross income, adding back any amount excluded as foreign earned income under 911(a)(1) (net of deductions and exclusions disallowed for that foreign earned income). September 8, 2014 39 Who is subject? Individuals, trusts, and estates. Individuals includes all shareholders or partners subject to NIIT on traditional pass-through investment income items. September 8, 2014 40 20

Threshold amount = for individuals, will depend on filing status: $250,000 for joint filers or surviving spouses $125,00 for married filing separately $200,000 for all other filers September 8, 2014 41 These amounts are not indexed for inflation, so unless Congress changes the law, more and more people are going to find themselves subject to the surtax. For trusts and estates, the surtax is the lesser of undistributed net investment income, or the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins (for 2014, that is $12,150) (see Rev. Proc. 2013-55). This amount IS inflation-adjusted, and will change year-toyear. There are many trusts and estates that are NOT subject to the NIIT, including: Charitable trusts and qualified retirement plan trusts that are tax-exempt under 501. Grantor trusts. Trusts that are not classified as trusts for federal income tax purposes, such as REITs or Common Trust Funds. September 8, 2014 42 21

How are passive activities taxed? General rules 1.1411-5 NII derived from a T or B includes income from trades or businesses that are passive activities within the meaning of 469. Overlap with 469 rules for definitions: 469(j)(8) income received in connection with the use of certain tangible property (such as equipment) is also deemed a rental activity. Such income from equipment rental would generally be passive and subject to the NIIT Exceptions under 1.469-1T(e)(3)(ii). September 8, 2014 43 Real Estate activities If a taxpayer meets the requirements to be an Real Estate professional under the PAL rules (above), the taxpayer s rental Real Estate activities will not be passive if the taxpayer materially participates in those activities, and will not be subject to the NIIT. However, for purposes of the NIIT, the taxpayer must go further and show that the activity actually constitutes a trade or business to the taxpayer under Section 162. Therefore, not all Real Estate professionals will be exempt from the NIIT. September 8, 2014 44 22

However, the 1411 regulations provide a safe harbor to address the trade or business test for Real Estate professionals: If the Real Estate professional participated in rental real estate activities for: More than 500 hours during the year. OR More than 500 hours per year in 5 of the 10 immediately preceding tax years. Then the rental income from that activity, as well as any gain or loss resulting from the disposition of the property, will be deemed to be derived in the course of a 162 trade or business (1.1411-4(g)(7). A Real Estate professional s hours do not count toward this threshold unless the Real Estate professional is performing services for the real estate activity. September 8, 2014 45 If Section 469 determines income is non-passive, does the income escape 1411? Example: Bob is a real estate broker who performs substantially all of the real estate activity under 1.469-5T(a)(2). Therefore, Bob meets the material participation standard required by the regulations to classify any income from the rental real estate activity as non-passive. Does this non-passive income escape 1411? September 8, 2014 46 23

Answer Not necessarily. We mentioned above that 1411 imposes a separate requirement on real estate activities. The activity must be a 162 trade or business to the taxpayer. As we said, a 162 trade or business is not well-defined, will be up to the taxpayer to show facts and circumstances that prove a trade or business (see above). Under this test for material participation, Bob only has to prove that he performs substantially all of the activity. That does not necessarily mean that his activity rises to the level of regular, continuous and substantial under 162. See T.D. 9466- Tax on net investment income of individuals, Preamble to the Final Regulations, Section E (Dec. 2, 2013). The IRS has ruled that reliance on the 1.469-5T material participation tests as a proxy to establish a 162 trade or business activity is not appropriate, or sufficient. September 8, 2014 47 162 allows for exclusion from NII? Example: Lola is an individual who owns an interest in UTP, a partnership which is engaged in a real estate trade or business. UTP owns an interest in LTP, which is not engaged in any trade or business. LTP receives $10,000 in rents, $5,000 of which is allocated to Lola through her interest in UTP. What is the result? September 8, 2014 48 24

The $5,000 of rents is not considered derived in a trade or business because LTP is not engaged in a trade or business under 162. (See 1.411-4(b)(2)(i). This is true even though UTP is engaged in a real estate trade or business. Therefore, Lola s $5,000 from UTP is NII to her. September 8, 2014 49 What is the result if Lola received that same $5,000 from UTP, and there was no LTP? Rule under 1.411-4(b) allows for an exception to NII if gross income from rents, interest, royalties, etc. is derived in the ordinary course of a 162 trade or business. When an individual, trust or estate owns an interest in a pass-through entity, and that pass-through is engaged in a trade or business, the determination of whether gross income from rents, interest, dividends, etc. is derived in a real estate trade or business is made at the owner level. September 8, 2014 50 25

Planning Example utilizing suspended PALs to show how utilization of PALs can generate tax sheltered income and optimize after tax cash. Facts: Sarah is a limited partner in QRS Partnership (does not materially participate). Sarah holds a limited partnership interest of 25% and has a negative capital account of $100,000. Sarah also has suspended PALs from QRS in the amount of $50,000. QRS Partnership holds majority interests in ABC and XYZ Partnerships. September 8, 2014 51 Alternative fact #1: Sarah earns $500,000 MAGI excluding any capital transactions in 2014. OR Alternative fact #2: Sarah earns $190,000 MAGI excluding any capital transactions in 2014. Sarah is a single taxpayer. Sarah is a married joint return filer. September 8, 2014 52 26

Scenario #1 Sarah has all passive activity losses from QRS and no losses from other activities. ABC and XYZ Partnerships are in the 162 trade or business of real estate. Sarah sells her interest in QRS for $60,000 in 2014. September 8, 2014 53 Scenario #2 Same as Scenario #1, but now Sarah has other PAL carry forwards of $110,000. September 8, 2014 54 27

Scenario #3 Same as Scenario #2, but now Sarah has a capital loss carry forward into 2014 of $160,000. September 8, 2014 55 Scenario #4 Same as Scenario 1, but now Sarah has no suspended PALs and no capital loss carry forward. These fact patterns are reflected in the 16 example calculations that follow. September 8, 2014 56 28

Example 1: Single Taxpayer Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) Use of PAL @ 45% $22,500 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($50,000) MAGI $610,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $410,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $28,420 September 8, 2014 57 Example 2: Single Taxpayer Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 45% $22,500 Other PAL $110,000@ 45% $49,500 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) MAGI $500,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $300,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $77,920 September 8, 2014 58 29

Example 3: Single Taxpayer Negative capital account of ($100,000) Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 45% $22,500 Other PAL $110,000@ 45% $49,500 Cap Loss c/f $160,000 $48,000 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) Utilization of Capital loss C/F ($160,000) MAGI $340,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $0 MAGI less threshold $140,000 NII tax ( 0) Net Benefit $132,000 September 8, 2014 59 Example 4: Single Taxpayer Negative capital account of ($100,000) Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) No PALs 0 No Cap Loss c/f 0 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ( 0) MAGI $660,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $460,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $5,920 September 8, 2014 60 30

Now assume the following: Example 5: Single taxpayer Other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) Use of PAL @ 30% $15,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($50,000) MAGI $300,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $100,000 NII tax @ 3.8% on $160,000 ($3,800) Net Benefit $23,200 September 8, 2014 61 Example 6: Single taxpayer, other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 30% $15,000 Other PAL $110,000@ 30% $33,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) MAGI $190,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold ($10,000) NII tax @ 3.8% on $0 ( 0) Net Benefit $60,000 September 8, 2014 62 31

Example 7: Single taxpayer, other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 30% $15,000 Other PAL $110,000@ 30% $33,000 Cap Loss c/f $160,000 $48,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) Utilization of Capital loss C/F ($160,000) MAGI $30,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $0 MAGI less threshold ($60,000) NII tax ( 0) Net Benefit $108,000 September 8, 2014 63 Example 8: Single taxpayer, other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) No PALs 0 No Cap Loss c/f 0 MAGI for Section 1411 Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ( 0) MAGI $350,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $150,000 NII tax @ 3.8% on $150,000 ($5,700) Net Benefit $6,300 September 8, 2014 64 32

Assume the following: Married Filing Jointly taxpayer, other income of $500,000 Example 9: Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) Use of PAL @ 45% $22,500 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($50,000) MAGI $610,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $450,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $28,420 September 8, 2014 65 Example 10: Married Filing Jointly taxpayer, other income of $500,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 45% $22,500 Other PAL $110,000@ 45% $49,500 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) MAGI $500,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $250,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $77,920 September 8, 2014 66 33

Example 11: Married Filing Jointly taxpayer, other income of 500,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 45% $22,500 Other PAL $110,000@ 45% $49,500 Cap Loss c/f $160,000 $48,000 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) Utilization of Capital loss C/F ($160,000) MAGI $340,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $0 MAGI less threshold $90,000 NII tax ( 0) Net Benefit $132,000 September 8, 2014 67 Example 12: Married Filing Jointly taxpayer, other income of $500,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) No PALs 0 No Cap Loss c/f 0 MAGI for Section 1411: Other Income $500,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ( 0) MAGI $660,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $410,000 NII tax @ 3.8% on $160,000 ($6,080) Net Benefit $5,920 September 8, 2014 68 34

Assume the following: Married Filing Jointly Taxpayer, other income of $190,000 Example 13: Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) Use of PAL @ 30% $15,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($50,000) MAGI $300,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $ 50,000 NII tax @ 3.8% on $50,000 ($1,900) Net Benefit $25,100 September 8, 2014 69 Example 14: Married Filing Jointly Taxpayer, other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 30% $15,000 Other PAL $110,000@ 30% $33,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) MAGI $190,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $0 NII tax @ 3.8% on $0 ( 0) Net Benefit $60,000 September 8, 2014 70 35

Example 15: Married Filing Jointly Taxpayer, other income of 90,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) PAL $50,000 @ 30% $15,000 Other PAL $110,000@ 30% $33,000 Cap Loss c/f $160,000 $48,000 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ($160,000) Utilization of Capital loss C/F ($160,000) MAGI $30,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $0 MAGI less threshold ($60,000) NII tax ( 0) Net Benefit $108,000 September 8, 2014 71 Example 16: Married Filing Jointly Taxpayer, other income of $190,000 Sale of interest for $60,000 $60,000 Gain $160,000 Tax @ 30% ($48,000) No PALs 0 No Cap Loss c/f 0 MAGI for Section 1411: Other Income $190,000 Gain on sale of passive activity $160,000 Utilization of PAL carry forward ( 0) MAGI $350,000 NII tax on Lesser of NII or MAGI less threshold amount: NII $160,000 MAGI less threshold $100,000 NII tax @ 3.8% on $100,000 ($3,800) Net Benefit $8,200 September 8, 2014 72 36

SUMMARY-Net after Tax Benefits ATTRIBUTES TAXPAYER PAL-50,000 PAL-160,000 PAL + CL C/F Nothing Single Taxpayer Other Income -$500,000 $28,420 $77,920 $132,000 $5,920 Single Taxpayer Other Income -$190,000 $23,200 $60,000 $108,000 $6,300 Married Taxpayer Other Income-$500,000 $28,420 $77,920 $132,000 $5,920 Married Taxpayer Other Income-$190,000 $25,100 $60,000 $108,000 $8,200 September 8, 2014 73 QUESTIONS? September 8, 2014 74 37