Self-Rental Income is Not Subject to New 3.8% Investment Income Tax

(TD 9644 Provides Finalized Regulations that Clarify Code Section 1411)

Stan Rose, Managing Director, Tax Practice
December 2013

Yesterday, the Treasury Department released Final Regulations (TD 9644) that resolve significant ambiguity regarding the applicability of a new 3.8% tax to certain rental income known as recharacterized or self-rental income.  Recipients of rental income, including those who own rental property indirectly through a “flow-through” entity (LLC, partnership or S Corporation) who are also involved with the operations of the tenant should be familiar with the new rules.  A common scenario this will apply to is one in which a business owner/operator, generally for legal liability purposes, holds real estate in one entity and an active trade or business in another entity, with the latter paying rent to the former.  Until now, it appeared possible that a new 3.8% tax could apply to such rental income.

Familiarity with several complex tax rules is necessary to understand the significance of the new clarification, and we will provide an overview here for those readers who will find it helpful.  Those readers who already are familiar with issues raised in recent months with the interaction of the 3.8% tax and the passive activity self-rental rules may want to skip over the background paragraphs to the last section of this article. Also, note that TD 9644 addresses a broad range of topics applicable to the new 3.8% tax, but this article addresses only the self-rental provisions.

Background – the “net investment income tax”
Section 1411 of the Internal Revenue Code became effective at the beginning of this year.  Designed to help fund the Affordable Care Act (“Obamacare”), it imposes a 3.8% tax on certain investment income, including most rental income.  Specifically, it is equal to 3.8% of the lesser of two amounts: (1) net investment income or (2) the excess of modified AGI over a threshold amount. The threshold amounts are:

  1. For taxpayers filing joint returns or surviving spouses: $250,000;
  2. For married taxpayers filing separate returns: $125,000;
  3. For all other individual taxpayers: $200,000;
  4. For estates and trusts: The dollar amount at which the highest tax bracket begins (currently $11,950).

There are certain exceptions to the rules that generally allow taxpayers who are employed as real estate professionals to avoid paying this tax.  The rules are complex, and a casual renter generally will not qualify.

Background - passive activities in general
Long before the 3.8% tax was imposed, many tax laws existed that restrict a taxpayer’s ability to deduct so-called “passive losses.”  The rules, found under Section 469 of the Internal Revenue Code, are very complex, and will be addressed very generally here.  In a nutshell, passive losses usually cannot be used to offset income that is not passive.  For example, on a taxpayer’s Form 1040, passive rental losses cannot lower overall income by offsetting wages or interest income.  Instead, passive losses can only offset passive income.  Income from one passive activity can be reduced or eliminated with losses from another passive activity, but if there is no such passive income to offset, any excess losses must be carried forward for potential use in a later year.

Background - passive activities and the self-rental rule
Years ago, the IRS perceived the potential for certain taxpayers to artificially accelerate deduction of passive losses, so it conjured up the “self-rental” rule described in Reg. 1.469-2(f)(6).  This provision applies only to individuals who collect rental income (directly or through a “flow-through” entity) from a tenant (generally another entity) when the individual “materially participates” in the activity of that tenant.  (In other words, one individual, directly or indirectly, is in some capacity functioning as both landlord and tenant.)  The IRS’ concern and the self-rental rule can best be explained by example:  Alison collects rent from several different tenants.  Most tenants are unrelated to her, but one tenant is an S corporation (a widget-maker) which she owns and operates.  Because it a flow-through entity, the S corporation income of $200,000 is reported on Alison’s 1040.  If the unrelated rental activities produce (nondeductible) passive losses of $20,000, and her widget-maker rental activity breaks even, Alison would report total income of $200,000, because the loss of $20,000 is suspended until a later year under the passive activity loss rules.

What is to stop Alison, who controls both the S corporation and the related rental activity, from increasing its rental payments by $20,000, simply moving income from one entity to another?  Her purpose in doing so would be to create passive income to absorb the passive losses, rather than seeing it suspended for use in another year.  If she made that adjustment, her combined rental income would be $-0-, and her widget income – and her total income – would be $180,000.  Solely by adjusting payments between two endeavors she controls, she immediately utilizes passive losses, thereby lowering her income and reducing her current tax. 

Alison’s plan will not work.  The self-rental recharacterization rule in Reg. 1.469-2(f)(6)  closed down this possibility by causing income from the S corporation to be treated as non-passive for this purpose only (unable to be netted with other passive activities).  It represents the classic “heads I win, tails you lose” scenario for the IRS, because self-rental income cannot be netted with other passive losses (which would help the taxpayer), but if the self-rental activity instead produces a loss, it still must be suspended (it cannot offset things like wages or interest income, which also would help the taxpayer).  Recall that these self-rental re-characterization rules apply only when property is rented to a trade or business activity in which the taxpayer “materially participates,” such as our widget-maker.

The issue and its resolution
With apologies for the lengthy background, how this existing self-rental rule interacts with the new 3.8% tax is the heart of this matter.  When this 3.8% tax was rolled out, it was clear that it was supposed to apply to true passive investment income, rather than income generated from active participation in a trade or business.  It seemingly should not penalize those who break out their real estate from their business operations, relative to a similarly-positioned taxpayer who holds them in one entity.  Many tax accountants and attorneys assumed that if a rental activity was “tainted” under the self-rental rules for regular income tax purposes (considered “active” due to its close connection with an operating trade or business), that tainting would serve to remove that particular rental income from the grasps of the new 3.8% passive investment tax (it should be active, instead of passive, for that purpose as well).  However, while that assumption is logical, the law did not specifically address this, and a literal interpretation left many believing there was no such relief, and most rental income would be subject to the new tax.

TD 9644 resolved this issue by making it clear that if an individual derives rental income from a business activity in which the individual is materially participating, the 3.8% tax will not apply.  Section 1.1411-5 of TD 9644 reads: “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.”  Note that the self-rental rules are applied on a person-by-person basis.  It will be common to have multiple owners in a rental entity, with some owners who are subject to the 3.8% tax and some owners who are not – depending on whether or not they are active participants in the trade or business of the tenant.

TD 9644 contains very good news for rental income recipients who actively participate in operations of their tenants.  The IRS solicited comments based on previously-issued Proposed Regulations, which did not resolve this issue.  Many tax practitioners pointed out to the IRS the disparity that would result in the absence of clarification, and the IRS listened.  (It is nice to see that the system works!)  The impact of this rule will be very significant to many taxpayers who own rental property, and it may help them avert either paying the new investment income tax or undertaking expensive restructuring to avoid it.

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