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Dec 2013
09
December 09, 2013

US Treasury Issues Final Regulations on Net Investment Income Tax that Clarify Treatment of Rental Property


Last week the U.S. Department of the Treasury issued Final Regulations addressing the net investment income tax provisions of IRC §1411. These Final Regulations modify certain provisions of the Proposed Regulations that were issued in December, 2012.

On October 29, 2013 we issued an E-Alert that describes planning opportunities under the Proposed Regulations dealing with rental income. The E-Alert (which can be viewed here) states that under the Proposed Regulations, individuals with real estate rented to a related business entity should consider a “grouping” election to essentially combine the rental activity with the operating business activity for purposes of determining whether the combined activity is a passive activity with respect to the individual. An individual’s material participation in the operating business activity would mean that income from the grouped activity would not be passive income subject to the net investment income tax.

The October 29, 2013 E-Alert also indicated that under the Proposed Regulations, including language in the Preamble to these Regulations, clients should consider modifying leases between the rental entity and the operating business entity so that income from the rental activity would qualify as a trade or business income not subject to the net investment income tax. We also mentioned that the final regulations may eliminate the need to amend lease arrangements.

The Treasury received substantial comments from the American Bar Association, the American Institute of CPAs and others that questioned certain provisions of the Proposed Regulations. Many of these comments were critical of the apparent requirement that leases might need to be modified even where a grouping election is made. Other comments suggested that the Treasury should be consistent, and that rules which recharacterize certain passive income as “nonpassive” for purposes of the passive loss rules should also apply in determining the character of the income under the net investment income tax rules. These recharacterization rules generally apply where property is leased to a business in which the property owner is a material participant.

The Treasury responded to the comments by making significant changes in the Final Regulations. The Final Regulations generally provide that gross rental income that is treated as nonpassive trade or business income under the recharacterization rules, or under a grouping election, is treated as nonpassive trade or business income under the net investment income tax provisions. This change in the Treasury position generally means that leases to related entities do not need to be amended to create trade or business income exempt from the net investment income tax.

For more information, please contact any of our Tax Law or Real Estate attorneys.

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