IRS Finalizes and Proposes Additional Regulations on 3.8 Percent Net Investment Income Tax

Dec. 5, 2013

On Dec. 2, the IRS issued final regulations as well as proposed regulations  that implement the 3.8 percent tax on net investment income (NII). The final and new proposed regulations provide relief in many areas. Following are highlights of the new guidance:

  • The final regulations provide relief for taxpayers who rent property to activities in which they materially participate. The typical situation to which this applies is a privately held business where a separate legal entity owns real estate that is leased to the operating business. Under the proposed regulations, the rental income generally would have been subject to the tax on NII. The final regulations provide that rents derived from leases to activities in which the taxpayer materially participates generally will be exempt from the tax on NII. This should be the case even if the leases are net leases.
  • The final regulations contain a safe harbor for rental income of real estate professionals. Under the safe harbor, if a real estate professional participates in rental real estate activities for more than 500 hours per year (or more than 500 hours per year in five of the past 10 taxable years), the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business and should not be subject to the tax on NII. For purposes of this safe harbor, the definition of real estate professional is the same definition established under the passive loss rules.
  • Gain on the sale of a pass-through entity generally is subject to the tax on NII, but an exclusion is available when the individual selling the interest materially participates in one or more of the activities of that pass-through entity. The original proposed regulations, which have since been withdrawn, imposed a significant reporting burden on partnerships and S corporations when an owner sold an interest in the entity. Under the new proposed regulations, the seller’s computation of gain subject to the tax on NII has been simplified, and the reporting burden on the pass-through entity has been reduced.
  • The final regulations allow for a portion of a taxpayer’s net operating loss (NOL) attributable to NII to be used to reduce NII in the year the NOL is used to reduce taxable income. This new provision could affect taxpayers’ 2013 and 2014 decisions to elect to forgo net operating loss carrybacks.
  • The new proposed regulations clarify that guaranteed payments for services are not included in NII, but guaranteed payments for the use of capital will be included in NII as the IRS views these items as a substitute for interest income.
  • The new proposed regulations have been issued that address the NII treatment of liquidating distributions to partners. The proposed regulations generally align the NII characterization of these payments with the treatment of the payments as passive or nonpassive under the passive activity rules, with passive items being included in NII.

The final regulations are effective for taxable years beginning after 2013, but taxpayers may rely on them for 2013. Although proposed regulations generally are not effective until finalized in the Federal Register, the IRS has indicated that taxpayers may also rely on the new proposed regulations for 2013.

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Howard M. Wagner
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