The 3.8% Section 1411 Obamacare net investment income tax is absurdly complicated and poorly-designed to start with. When the Treasury drafted their first set of proposed regulations, they seemed determined to make it even worse. Taxpayer response was harsh, and the final rules put in place last week fix some of the worst problems in the original rules.
This tax applies to taxpayers with “modified” adjusted gross incomes over threshold levels of $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for other individuals. It also applies to all top-bracket trusts. It applies to “net investment income” to the lesser of Net Investment Income or the amount modified AGI exceeds the threshold. It applies to all trust AGI over the top trust tax bracket amount.
Net Investment Income includes interest, dividend, capital gains, passive K-1 and other business income, royalties, non-qualified annuities, and rents. It excludes non-passive K-1 income, wages, self-employment income, capital gains on the sale of a partnership or S corporation where the seller is non-passive, and “trade or business” rents for non-passive taxpayers. A few highlights of the changes in the final regulations:
Self-rental. The proposed regulations said that taxpayers who rent property to their non-passive trade or business have net investment income from the rents. The final regulations say self-rental income from property rented to non-passive activities is not subject to the tax.
This is very helpful. Under the old regulations, there would have been a big incentive for businesses that rent property from their owners to restructure so that they own the rental property. This is no longer necessary.
Material Participation Rental. The proposed regulations would have imposed the net investment tax on most rental activity income even where the taxpayer is “non-passive” on the rental. They required taxpayers to demonstrate that their rental activity rose to the level of a “trade or business,” a vague standard, to avoid the tax. The new regulations add a safe-harbor where taxpayers who work at least 500 hours in a rental activity are deemed to rise to the level of having a “trade or business.”
Sales of a business. The proposed regulations required taxpayers selling even a small interest in a partnership or S corporation to identify the inherent gain or loss in each asset owned by the partnership or corporation to determine how much of the gain or loss on the sale was passive, and therefore subject to the tax.
They withdrew that proposal and issued a new proposed regulation that includes a safe-harbor that uses historic K-1 information to compute the portion of a gain of an S corporation or partnership interest to compute the “net investment income” portion. Absent such a provision, compliance would have been impossible in many or most cases involving a sale of a minority interest. They should add a de-minimus standard to avoid the computation altogether when non-passive amounts are a trivial portion of the K-1 income.
The tax should still be repealed. It imposes a whole new fiendishly complex tax on a narrow subset of income. It violates any standards of good tax policy. But we have to live with it until Congress and the President come to their senses, and there is no sign of that happening.
MATERIAL PARTICIPATION BASICS
The regulations say you achieve “material participation” in non-real estate activities for a tax year if:
-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other “100 hour” activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).
There is also a “facts and circumstances” test, but don’t count on it.
A special rule apples to real estate. If you are not a “real estate professional,” losses are normally passive no matter what, unless you provide “extraordinary” personal services.
If you are a “real estate” professional,” you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours – and not less than 750 hours annually – in “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade.”