1

§1411, Passive Activities and Planning Opportunities

AGC Financial Issues ForumJanuary 2014

2

The material appearing in this presentation is for informational purposes

only and should not be construed as advice of any kind, including, without

limitation, legal, accounting, or investment advice. This information is not

intended to create, and receipt does not constitute, a legal relationship,

including, but not limited to, an accountant-client relationship. Although

this information may have been prepared by professionals, it should not

be used as a substitute for professional services. If legal, accounting,

investment, or other professional advice is required, the services of a

professional should be sought.

3

AGENDA

• Definition of §1411• Trade or Business Determination• Grouping Rules• Real Estate Professional • Self-Rental Rules• Self-Interest Rules• Former Passive Activities

4

SECTION 1411 – MEDICARE CONTRIBUTION TAX OR NET INVESTMENT INCOME TAX

• For each tax year, the tax is equal to 3.8% of the lessor of:

1. net investment income for the tax year, or

2. the excess (if any) of the modified adjusted gross income for the tax year over the threshold amount which is $250,000 MFJ or $200,000 Single.

5

PERSONAL INCOME TAX: NET INVESTMENT INCOME TAX

What is included in net investment income? Interest Dividends Capital gains Rents Royalty income Nontrade or business income Any other passive income

(where taxpayer does not materially participate in the business)

6

PERSONAL INCOME TAX: NET INVESTMENT INCOME TAX

What is excluded from net investment income?

Wages Self-employment income Active trade or business income Retirement plan distributions Alimony Social Security benefits Interest from tax-free bonds Unemployment compensation Gains excluded from gross income for regular income tax

purposes

7

TRADE OR BUSINESS DETERMINATION

Ordinary Course of Trade or Business Exception• Certain income earned in the ordinary course of a

trade or business is exempted from § 1411• Ordinary course of a trade or business is a two

part test• Income must be derived in a “trade or business”

that is not passive or trading financial instruments• Income and expenses must be derived in the

“ordinary course” of such trade or business

8

TRADE OR BUSINESS DETERMINATION

• Neither §1411 nor the §1411 Regulations define a “trade or business,” but describe it as conducting a trade or business within the meaning of §162

• Passive determination for disregarded entities and interests held in pass through entities is made at the taxpayer level (individual, estate, or trust) in accordance with the principals of § 469

• Income earned from interests held in tiered pass through entities preserves is character as active, passive or trading in financial instruments as it flows up through the various tiers of ownership

9

RENTAL TRADE OR BUSINESS

• Determination based on case law – much of it old case law – facts and circumstances intensive

• Focus is on regular and continuous activities related to the rental property

• Significant incidental services provided to tenants is indicative of trade or business

• Activities may be performed by a manager • Number of buildings owned may be

determinative

10

GROUPING ACTIVITIES

• Reg. 1.469-4(c)(2) identifies the following factors to consider in determining whether activities constitute an appropriate economic unit:

1. Similarities and differences in types of trades or business

2. Extent of common control and ownership

3. Geographic location

4. Interdependencies between the activities

11

GROUPING RENTAL ACTIVITIES WITH A TRADE OR BUSINESS

A rental activity may not be grouped with a trade or business activity unless the grouping constitutes an appropriate economic unit and;

1. the rental activity is insubstantial in relation to the business activity (or vice versa) or

2. each owner of the trade or business activity has the same proportionate ownership interest in the rental activity

12

MATERIALLY PARTICIPATING REAL ESTATE PROFESSIONALS – SAFE HARBOR (NEW)

• The final regulations provide a safe harbor offering relief from the 3.8 percent NII tax for rental income of real estate professionals derived in the ordinary course of a trade or business.

• The safe harbor provides that if a real estate professional participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business, and thus not subject to section 1411.

13

MATERIALLY PARTICIPATING REAL ESTATE PROFESSIONALS – SAFE HARBOR (NEW)

• CAUTION: The preamble to the final regulations states that “not all of the material participation tests provide conclusive evidence that a taxpayer is regularly, continuously, and substantially involved in a rental trade or business within the meaning of section 162.” Therefore, the only test that is applicable for this safe harbor is the 500-hour test.

14

§ 469 ACTIVITY REGROUPING FOR §1411 – A FRESH START

• Regrouping election available for first year §1411 applies

• Rev. Proc. 2010-13 disclosure requirements apply• May regroup on amended return but only if the

taxpayer was not subject to 1411 on original return• Final regulations do NOT allow regrouping by

partnerships and S corporations• §469 grouping rules apply

o Does not convert rents to T or B incomeo Standard grouping restrictions apply

15

SELF-RENTAL RULES

• Self rental exists where taxpayer rents property to a non-passive activity in which taxpayer owns an interest

• Amount of ownership generally disregarded• Re characterizes rental income as non-passive• Re characterizes asset sale as non-passive• Rental loss remains passive• Final regulations state that self-rental income is not

subject to 1411• Final regulations provide that any gain or loss from the

assets associated with that rental activity will be treated as non-passive

16

SELF CHARGED INTEREST

Self Charged Interest• In the case of self-charged interest from a

nonpassive entity, the amount of interest income excluded from NII is the taxpayer’s allocated share of the nonpassive deduction.

• This rule does not apply where the interest deduction is taken into account in determining self-employment income.

17

FORMER PASSIVE ACTIVITIES (FPAS)

• Passive loss rules applied on a year by year basis• Passive activities may become non passive from

material participation or becoming a real estate professional

• Special rules apply to former passive activitieso Suspended passive losses from the FPA are carried

forward and applied first against current year income from that activity

o Any remaining suspended passive losses continue to be treated as passive losses

18

QUESTIONS??