Avoiding the NIIT with Rental Real Estate. Chapter 11

Transcription

1 Avoiding the NIIT with Rental Real Estate Chapter 11 To escape the NIIT, rental real estate must be: 1) A Trade or Business (T or B), and 2) Nonpassive (sec. 469) 2

2 T or B (v. investment) status for rental real estate is relevant beyond merely the NIIT 3 NOL Home Office Deduction Section 1231 loss Forfeited Down Payments (an ordinary loss if a T or B.) 4

3 When is rental real estate a T or B? For purposes of the NIIT: [t]he term trade or business refers to a trade or business within the meaning of section 162. (Reg (d)(12)) 6

4 When is rental real estate a Section 162 trade or business? Caselaw 7 Case law rarely involves section 162 because rental deductions are above AGI whether the deductions are allowed by section 162 or

5 Litigated decisions involving the trade or business status of rental real estate for purposes of section 1221 emerged in the 1940s through the 1950s. 9 Campbell v. Comm r, 5 TC 272 (1945) Taxpayer inherited residential property in 1934 and tried to rent or sell it. Never used it as his residence, and 10

6 attempted to rent it (unsuccessfully), until it was sold in 1941 at a loss. Campbell sought ordinary loss treatment under the predecessor to section 1221(a)(2), which required the property to be a trade or business asset. 11 The Tax Court Found a Trade or Business 12

7 Cited Jephson v. Comm r, 37 BTA 1117 (1938), with similar facts. BTA said the taxpayer was carrying on a business, albeit without actual profit during the years in question. 13 Caselaw on Attempted Rentals Purchased For Personal Use No Loss on Sale Inherited Capital Loss or Sec Loss on Sale Purchased To Rent (T or B) Section 1231 Loss on Sale

8 In Hazard v. Comm. r, 7 T.C. 372 (1946), acq CB 3 A single family residential rental in Kansas City was viewed as a trade or business of the taxpayer and thus produced an ordinary loss on sale under the predecessor to sections 1221(a)(2) and Mr. Hazard lived in Pittsburgh (several hundred miles away) and devoted his entire time to his job as general counsel of a Pittsburgh company. 16

9 The Tax Court cited Jephson and Campbell approvingly. Did not specify any details about services provided to the tenants and did not discuss the lease terms. 17 Hazard Tax Court Implication: Minimal management activity is needed to establish a trade or business for rental real estate. 18

10 T or B Test v. Sec. 469 Mat. Part. (MP) Test: The T or B test looks at both taxpayer participation and work done by agents of the taxpayer. Ex.: T spends 24 hours per year managing a commercial bldg. by hiring agents to do the work = T or B. (Fackler) 19 Sec. 469 MP test looks exclusively at taxpayer participation and work done by agents is a negative. Ex: Under 100 hrs and T does substantially all of the work = MP (devalues delegation skills and principal-agent relationship) 20

11 Second Circuit applied a tougher test in Grier v. U.S., 218 F.2d 603 (2nd Cir. 1955) (Rejected Hazzard) 21 Grier required a broader activity than a single residential rental, long-term (14 years), to one tenant, with minimal repair activity. Ruled that the rental was an investment activity. 22

12 Grier referred to: Pinchot (eleven commercial buildings in New York), Gilford (eight buildings in New York), Fackler (a six-story commercial building), and Rogers (sixty-one properties). 23 The Tax Court only follows Grier in the Second Circuit (Golsen Rule) 24

13 Balsamo v. Comm r, TC Memo (1987) [The Tax Court s] position [implicitly contrary] is not controlling for purposes of our decision today. We must decide this issue pursuant to the law as articulated by the Second Circuit [per Golsen]. The case of Grier provides the basis for our conclusion. (Citations omitted). 25 Reiner v. U.S., 222 F.2d 770 (7th Cir. 1955) The issue was whether the taxpayer, living in the U.S. could carry back and forward her NOL resulting from the 1944 bombing raid on her rental property (former primary residence) in Austria during WW2 (confiscated by the Nazi gov t for 5 years). 26

14 Management Activity Discussed in the Case When taxpayer left Austria [in May 1938] she appointed Dr. Bruno Erhardt to manage the property for her and he rented it to several tenants. No rental payments were actually received by taxpayer, and she did not account for same in her income tax returns. 27 The district court had also noted: Dr. Erhardt rented the property in the latter half of 1938 and the property remained rented since that time. 28

15 Reiner, Quoting the Tax Court in LaGriede: It is clear from the facts that the real estate was devoted to rental purposes, and we [the Tax Court] have repeatedly held that such use constitutes use of the property in trade or business, regardless of whether or not it is the only property so used. 29 We add that the use of the property in trade or business was, upon the facts, an operation of the trade or business in which it was so used. It is clear, also, that the business was regularly carried on, there having been no deviation, at any time, from the obviously planned use. Factually indistinguishable from Grier. 30

16 Stratton v. Comm r, TC Memo (1962), Full-time attorney who sold at a net loss, a singlefamily residence that had been rented to the same tenant for three years. Taxpayer sought capital loss treatment. 31 IRS argued that the mere renting of the house for the [threeyear period] constituted the carrying on of a trade or business. 32

17 Tax Court agreed with IRS: This [Tax] Court has repeatedly held that the renting of improved real estate constitutes the carrying on of a trade or business, regardless of whether or not the taxpayer engaged in any other trade or business, [citing Hazard, Jephson and another case] 33 Does the Tax Court ever treat a rental as an investment? Yes! 34

18 Triple Net Lease Property A triple-net lease in which the tenant is responsible for taxes, insurance, and repairs, is normally a mere investment. Herbert v. Comm r, 30 T.C. 26 (1958) 35 The NIIT Regulations imply a high bar to reach T or B status for rental real estate 36

19 NIIT Final Reg. Preamble The Treasury Department and the IRS agree with commentators [on the proposed regs.] that, in certain circumstances, the rental of a single property may require regular and continuous involvement such that the rental activity is a trade or business within the meaning of section However, the Treasury Department and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law. Neither does any legal scholar believe this. It is a question of fact not a rule of law! (Groetzinger) 38

20 NIIT Final Reg. Example A, an unmarried individual, rents a commercial building to B for $50,000 in Year 1. A is not involved in the activity of the commercial building on a regular and continuous basis, therefore, A's rental activity does not involve the conduct of a trade or business, and under section 469(c)(2), A's rental activity is a passive activity [Therefore, A s rental income is subject to the 3.8% NIIT]. (Reg (b)(2) Ex. (1)) 39 But the IRS has never revoked its acquiescence to Hazard. 40

21 GCM (7/27/81) Chief Counsel rejected the National Office audit division request for a reversal of the acquiescence to Hazard. 41 In the typical case, the taxpayer has offered evidence of the various activities involved in managing the rental property and the court has accepted this evidence as indicating that the taxpayer was engaged in a trade or business.. 42

22 The problem that you raise is not with the legal standard applied by the courts, but with the relatively small amount of activity that the court have found to be indicative of a trade or business. In view of the number of cases that have been decided on this issue it is unlikely that the Service could now persuade the courts to take a more restrictive approach 43 McBride s Conclusion: The NIIT Regs., improperly, suggest a tougher T or B standard than even the Grier minority view. 44

23 The NIIT Regs. contain several useful safe harbors (detail below) that deem the rental to be a T or B. 45 When is rental real estate nonpassive under sec. 469?

24 A rental real estate activity is per se passive whether a T or B or not. (Section 469(c)(2): the term passive activity includes any rental activity. ) 47 Real Estate Professionals (Sec. 469(c)(7)) 48

25 Real Estate Prof. (REP) Per 469(c)(7) (1) > 50% of personal services are a real property trade or business (RPTB) in which T materially participates (2) Over 750 hours of services in an RPTB in which T materially participates. 49 RPTB sec. 469(c)(7) Real property development Redevelopment Construction Reconstruction Acquisition Conversion 50

26 Rental Operation Management Leasing Brokerage 51 For a married couple, one spouse must separately meet both requirements (but material participation is based upon combined participation) 52

27 The REP must own more than 5% of the RPTB 53 In Stanley, an attorney who performed primarily legal services for a real property management business was determined to be a REP (District Court). 54

28 A REP merely ducks the per se passive treatment that applies to a rental activity. The REP must materially participate in the rental activity in order to make the rental activity nonpassive and thus avoid the NIIT 55 Two (of Seven) material participation tests do not apply to rental real estate: 1) The test for significant participation activities (SPAs), and 2) The lookback test designed for personal service activities. 56

29 The five material participation tests that do apply: 1) T participates over 500 hours. 2) T performs substantially all of the participation in the activity by all individuals. 57 3) T participates for more than 100 hours and such participation is at least as much as every other individual; 4) T materially participated for five of the prior ten years; 58

30 5) T participates for more than 100 hours and based upon all of the facts and circumstances, T participates in the activity on a regular, continuous, and substantial basis during the tax year. 59 As a general rule, each interest in rental real estate of a REP is treated as a separate rental real estate activity 60

31 REPs are allowed by reg (g) to group multiple rentals into a single rental activity for purposes of testing for material participation by the REP (hereinafter: the REP aggregation election ). 61 The REP aggregation election must be made on the original return for the tax year, but if certain conditions are met, a taxpayer may be eligible to elect aggregation on an amended return (Rev. Proc ) 62

32 Example (1): Dana is a real estate broker who also owns two profitable rental properties 63 Sch. C Rental #1 Rental #2 2,000 Hrs 600 Hrs 20 Hrs 64

33 Real Estate Prof. (REP) Per 469(c)(7) (1) > 50% of personal services are a real property trade or business (RPTB) in which T materially participates (2) Over 750 hours of services in an RPTB in which T materially participates. 65 Sch. C Rental #1 Rental #2 2,000 Hrs 600 Hrs 20 Hrs Dana is easily a REP 66

34 Sch. C Rental #1 Rental #2 2,000 Hrs 620 Hrs The aggregated rentals are nonpassive and escape the NIIT if a T or B 67 Two NIIT T or B Safe Harbors For REPs (Reg. sec (g)(7)) 68

35 1) The rental is a deemed T or B for NIIT purposes if the REP materially participates in the rental real estate for over 500 hours. So Ex. 1, with aggregation, is a T or B 69 2) A deemed T or B if T participated in the rental over 500 hours for five of the prior ten years. Includes pre years 70

36 Example (2): Dana is a real estate broker who also owns two profitable rental properties 71 Sch. C Rental #1 Rental #2 2,000 Hrs 600 Hrs Triple Net Lease 24 hours Absent the REP aggregation election Rental #2 is passive and an investment property. 72

37 Sch. C Rental #1 Rental #2 2,000 Hrs Triple Net Lease 624 Hrs With REP aggregation election : a nonpassive T or B so no NIIT 73 The NIIT T or B Safe harbors for REPS also apply to sale gain 74

38 Example (3): Dana is a real estate broker who also owns two rental properties and assume Dana meets the facts and circumstances material participation test for rental #1 75 Sch. C Rental #1 Rental #2 2,000 Hrs 360 Hrs Triple Net Lease 24 hours 76

39 Sch. C Rental #1 Rental #2 2,000 Hrs 360 Hrs Triple Net Lease 24 hours The REP aggregation makes the rental nonpassive, but does not make it a T or B for Rental #1 or #2 (not over 500) 77 Failure to meet the >500 hour safe harbor does not prevent trade or business treatment for nonpassive rental real estate of a REP 78

40 Sch. C Rental #1 Rental #2 2,000 Hrs 360 Hrs Triple Net Lease 24 Rely on case law (Fackler) for Rental #1. Work by agents counts under the T or B test. Rental #2 is an investment. 79 Example (4): Same as Ex. (3) except Rental #2 is a gross lease. Dana hires numerous agents that work on Rental #2. For Rental #1, Dana meets the facts and circumstances material participation test. 80

41 Sch. C Rental #1 Rental #2 2,000 Hrs 360 Hrs Gross Lease 24 hours Use REP aggregation election to assure that all income is nonpassive. 81 Sch. C Rental #1 Rental #2 2,000 Hrs 360 Hrs Gross Lease 24 hours Rely on case law (Fackler) for both Rental #1 and #2. Work by agents counts under the T or B test. 82

42 Example (5): Dana is a retired doctor who owns two profitable rentals. Is she a REP? 83 Rental #1 Rental #2 Retired Doctor 350 Hrs. Gross Lease 350 Hrs 84

43 Real Estate Prof. (REP) Per 469(c)(7) (1) > 50% of personal services are a real property trade or business (RPTB) in which T materially participates (2) Over 750 hours of services in an RPTB in which T materially participates. 85 Retired Doctor Rental #1 Rental #2 350 Hrs. Gross Lease 350 Hrs Dana is not over 750 hours in RPTBs thus not a REP 86

44 Retired Doctor Rental #1 Rental #2 350 Hrs. Gross Lease 350 Hrs She is subject to the NIIT 87 Grouping Under (d) ( General Grouping ) Not Just REPs

45 How is a rental grouped into a nonrental? A rental activity may not be grouped with a [nonrental T or B] unless the activities being grouped together constitute an appropriate economic unit

46 AEU is based upon all facts and circumstances Factors given the greatest weight: Similarities and differences in types of trades or businesses; The extent of common control; The extent of common ownership; Geographical location; and

47 Interdependencies between or among the activities AND

48 (A) The rental activity is insubstantial in relation to the trade or business activity; (B), or (C) Each owner of the [nonrental T or B activity] has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the [nonrental T or B activity] may be grouped with the [nonrental T or B activity] (Reg (d))

49 Identical ownership (rental/nonrental) is the easiest fact pattern for general grouping. Example (1): Debbie is a CPA who also owns an S Corp. that operates a grocery store. Debbie also owns a building which she rents to the S corp. The S corp is profitable but the activity is passive for Debbie because she only participates for 101 hours (well below others) 98

50 CPA Debbie 100% D Participates 101 Hours RENT Profitable S CORP Grocery Store 99 The profitable S corp is a SPA but it is her only SPA so she is not a material participant. If the S Corp generated a net loss, it would be passive. If profitable, SPA income is recharacterized as nonpassive. 100

51 GROUP AS ONE BUSINESS ACTIVITY CPA Debbie 100% RENT Profitable D Participates 101 Hours S CORP Grocery Store Business Escapes NII 101 Because the rental becomes a nonrental (via general grouping), the SPA rule, in effect, applies to the rental. 102

52 The NIIT Regs. respect the SPA recharacterization rule so the income is nonpassive, also 103 A rental activity grouped into a nonrental business under the general grouping rules is deemed to be T or B for NIIT purposes even if a sec. 212 activity Reg (g)(6)(i) 104

53 TYBA Jan. 24, Relief for Profitable Self- Rentals (Reg. sec (g)(6)) 106

54 (f)(6) An amount of the taxpayer's gross rental activity income from an item of property equal to the net rental activity income from that item of property is treated as [nonpassive] if the property -- (i) Is rented for use in a trade or business activity * * * in which the taxpayer materially participates. Rental income and sale gain treated as nonpassive by reason of reg (f)(6) recharacterization is excluded form the NIIT Deemed T or B even if a sec. 212 rental Reg (g)(6)(i)

55 Recall that in Example (1) Debbie did not materially participate in the S corp. Reg (f)(6) recharacterization was not available to Debbie. General grouping was her only option in Ex. (1). 109 Example (2): Same facts as Ex. (1) except Debbie materially participates in the S Corp. 110

56 No Grouping CPA Debbie 100% Materially Participates RENT S CORP Profitable Business Nonpassive Gross income Escapes NII 111 Debbie is 10% S shareholder CPA Debbie 100% 10% Materially Participates RENT S CORP Profitable Business Nonpassive Gross income Escapes NII 112

57 Debbie is Partner 100% CPA Debbie 10% Materially Participates RENT Php Profitable Business Nonpassive Gross income Escapes NII 113 Debbie is a C corp Shareholder CPA Debbie 100% 10% Materially Participates RENT C CORP Profitable Business Nonpassive Gross income Escapes NII 114

58 If possible, Debbie may prefer to group the rental and nonrental in order to allow a loss on the rental to be nonpassive. 115 Example (3): Dana is a fulltime real estate broker and her business manages rental properties, including her own. Can she group her rental (to third parties) into the nonrental under the general grouping rules? 116

59 Sch. C 2,000 Hrs 20 Hrs Assume that Dana does not materially participate in the rental so not a REP. 117 Sch. C 2,020 Hrs 20 Hrs Arguably an appropriate economic unit and the rental is insubstantial relative to the nonrental 118

60 Short-Term Rental Real Estate (STRRE) (not a rental ) 119 Property rented out for periods averaging seven days or less are treated as nonrentals. 120

61 Vacation rentals and Airbnb rentals are common examples 121 Nonpassive if T materially participates. 122

62 Nonpassive income if a profitable SPA (over 100 hours) 123 Normally a gross lease so normally a T or B per the caselaw. 124

63 Sch. C 2,000 Hrs 20 Hrs Easier to Group under General Grouping Rule (no need to prove insubstantiality) 125 If STRRE produces a net loss, and the property is sec. 212 investment property, the passive loss rules do not limit the Sch E, sec. 62(a)(4), rental loss (not a passive T or B) 126

64 The Developer Rule 127 For a developer to establish that sale gain is attributed to rental activity (thus passive), the developer must rent the property for a minimum time period. (Generally, at least 12 months prior to selling the property.) 128

65 If the developer rule treats the rental gain as nonpassive (because the 12 month holding period was flunked), then the income escapes the NIIT. That said, developer sale gain is normally subject to SE tax ( held for sale ). 129 The Land Rental Rule 130

66 Under the PAL regs., income and sale gain from a rental activity is recharacterized as portfolio income (nonpassive) if the unadjusted basis of the depreciable property rented in the activity is less than 30% of the unadjusted basis of all property rented in the activity 131 The NIIT regs. reject the PAL recharacterization rule and treat the rental income as passive (same as investment income) 132

67 The NIIT treatment of land sale gain is ambiguous. 133 Stanley (DC AR) 11/12/2015 Fact Pattern

68 Glick 10% 2% to 20%? Materially Participates Rental Activity <$200K> <$300K> Real Prop. Mgt. $100K Nonrental Is Insubstantial With sec (d) general grouping, the $100K otherwise nonpassive income can offset the <$300K> passive rental loss thus reducing the PAL to <$200K> 136

69 Stanley facts match the Glick fact pattern but Stanley also claimed that he was a REP which made the rental losses nonpassive. 137 Stanley (Attorney) 10% 2% to 20%? Materially Participates Nonpassive Rental Loss Rental Of REP Activity -$300K <$200K> Real Prop. Mgt. $100K Nonrental Is Insubstantial + a REP Agg. Election

70 Holding #1: Attorney Stanley is a REP 139 Holding #2: 140

71 Judge Holmes concluded that Reg (e)(3)(i) does not prohibit a REP from using the general grouping rule of -4(d): For purposes of [determining material participation in the rental activity] in this section, a [REP] may not group a rental real estate activity with any other activity of the taxpayer. (Emphasis added)

72 For example, if a [REP] develops real property, constructs buildings, and owns an interest in rental real estate, the taxpayer's interest in rental real estate may not be grouped with the taxpayer's development activity or construction activity. Thus, only the participation of the taxpayer with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity under T. (Reg (e)(3)(i))

73 Per Judge Holmes, - 9)(e)(i) merely prevents T s material participation (MP) in a nonrental from counting in determining MP in the rental for purposes of making REP s rental losses nonpassive. So Stanley could use the general grouping rules.

74 Issue #3: Was Stanley allowed to count his participation in his management activity as participation in his rental activities? 147 Holding #3: Yes, Stanley s MP in the management activity counted as MP in his rental because of the exception in (e)(3)(ii) which says: 148

75 Reg (e)(3)(ii): A [REP] may participate in a rental real estate activity through participation in an activity involving the management of rental real estate (even if conducted through a separate entity). 149 In determining whether the taxpayer materially participates in the rental real estate activity, however, work the taxpayer performs in the management activity is taken into account only to the extent it is performed in managing the taxpayer's own rental real estate interests. 150

76 Issue #4: Stanley could not prove that his participation related to any particular rental property of his. Is that OK? 151 Holding #4: Yes, Stanley s management activity was a rental real estate interest by virtue of the general grouping rules, so: 152

77 All of Stanley s MP in his management activity counted as MP in his rental activity per Reg (e)(3)(ii). 153 Is Stanley too risky as a means of avoiding the NIIT with profitable rental real estate?

78 Stanley 10% 2% to 20%? Materially Participates Profitable Rental Activity $300K Real Prop. Mgt. $100K Stanley 10% 2% to 20%? Materially Participates Nonpassive Profitable Rental Activity Rental Activity $400K $300K Real Prop. Mgt. $100K

79 If Judge Holmes interpretation of is incorrect, then is the taxpayer subjecting his/her management activity to the NIIT by making it a profitable rental under the general grouping rule? No because the management activity income is subject to SE tax regardless of how the activity is grouped for section 469 purposes. (so it is worth a try)