The Net Investment Income Tax was created by the Affordable Care Act and imposed a 3.8% tax that applies to individuals, estates and trusts that have certain investment income above specific threshold amounts. The threshold amounts are based on modified adjusted gross income and are $250,000 for married individuals filing jointly,$125,000 for married individuals filing separately and $200,000 for all others. The tax became effective January 1, 2013 and the IRS recently issued lengthy final regulations. In general, the final regulations follow the approach of the proposed regulations with some modifications in response to comments and questions that have arisen. The law created three categories of net investment income:
i. Gross income from interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payments,
ii. Other gross derived from a trade or business or trading in financial instruments or commodities or an activity that is passive to the taxpayer; and
iii. Net gain attributable to the disposition of property.
The IRS declined to exempt the net investment income tax from the estimated tax payment requirements, even though many investors cannot know until the end of the year if a passthrough investment will generate net investment income. The IRS also clarified that foreign income taxes are not creditable against the net investment income tax because it is not contained in chapter 1 of the Internal Revenue Code.
Among the changes is a safe harbor for real estate professionals. 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. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last ten taxable years (one or more of which may be taxable years prior to the effective date of Section 1411 of the Tax Code), then the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business. The safe harbor test also provides that, if the hour requirements are met, the real property is considered as used in a trade or business for purposes of calculating net gain.
For example, if a farmer has created a LLC to own farm land which rents the land to his schedule F operation, this will not be subject to the 3.8% net investment income tax. However, if an individual is an active investor in farmland property and does not have any farm operation or never had a farm operation, then it is likely that the rental income will be subject to the new 3.8% tax. This would include any gain from selling the land.
The Treasury Department and the IRS said they recognize that some real estate professionals with substantial rental activities may derive such rental income in the ordinary course of a trade or business, even though they fail to satisfy the 500-hour requirement in the safe harbor test. As a result, the final regulations specifically provide that such a failure would not preclude a taxpayer from establishing that the gross rental income and gain or loss from the disposition of real property, as applicable, is not included in net investment income.
The IRS also issued new proposed regulations offering an approach towards determining the amount of gain from the sale of S corporation stock or a partnership interest that must be included in net investment income as well as a shortcut approach.
If you believe you may be subject to this additional tax and have questions, please contact Steve Siesser at firstname.lastname@example.org