Final Regulations Give Certain Real Estate Owners Relief from the New Net Investment Income Tax

Last month, as we were gathering with family and friends to enjoy the Thanksgiving holiday and some wonderful food, the Internal Revenue Service issued their final regulations guiding taxpayers on how to calculate the new Net Investment Income Tax.

It has been a year since the IRS issued proposed Net Investment Income Tax regulations last December. Almost instantly after the release, tax professionals were asking the Service for some leniency from some of the harsher provisions of the proposed regulations. In response, on November 26th, 2013, the IRS issued new regulations which incorporate some but not all of the suggestions from the tax professional community. While a discussion of all of the changes is beyond the scope of this article, we want to make you aware of one significant area of relief for certain real estate owners.

One of the concerns raised by many was the potential tax on self-charged rental income. In a typical situation, a business owner holds the real estate in which his/her business operates in a separate entity. This related rental company will then charge the operating business rent for the use of the property. Under the proposed regulations, the IRS was saying that this self-charged rent was potentially subject to the Net Investment Income Tax. The outcry from taxpayers was loud and wide. Many in the tax community recommended relief in various forms from this additional tax.

In a reversal of its proposed position, the IRS has not only granted relief but also gone beyond the expectations of some. Specifically, the IRS granted relief from the Net Investment Income Tax on self-rentals in two specific circumstances. In the first scenario, the property is not subject to the tax if the net rental income is attributable to a business in which the taxpayer actively participates. In the second scenario, the property is not subject to the net investment income tax if the taxpayer has elected to treat the business and the rental entity as one activity, and the taxpayer materially participates in the combined activity. Please note that the rental activity may only be grouped with the operating business if the two entities have identical ownership, or if the rental activity is insubstantial in relation to the business activity, or vice versa.

Significantly, the IRS has gone on to say that when the property is sold, there is the potential to avoid the Net Investment Income Tax on the gain or loss from the disposition. This will be welcome news to many taxpayers as the gain from the sale of real estate can sometimes be significant.

The rules for this exclusion from the Net Investment Income Tax are more complex than discussed in this article. Additionally, there may be elections that you need to make in the first year that you are subject to the Net Investment Income Tax. Accordingly, we recommend that you contact your BT advisor to discuss how you might take advantage of the relief provided by the final regulations if either of the above circumstances describes your situation.

If you think you may be affected by these new regulations, please contact Partner Trey Webb or call 770.396.2200.