FROM FORBES.COM -
Well, our long national nightmare is finally over. This morning, the IRS
released 20-page DRAFT instructions to go with the previously issued DRAFT
Form 8960. Note, the previously issued Form 8960, which you can find here,
was not changed at all. The IRS merely issued instructions to aid in the
population of the 33 total lines found on the draft form.
I read through the instructions this morning, and while they align perfectly
with the content of the final regulations, I have a couple of thoughts and
observations.
Don’t rely on the software.
As I just said, the instructions are very thorough, and clearly implement the
overwhelming majority of the principles found in the final regulations,
including the exclusions from net investment income for certain self-rental
income, self-charged interest, and rental income of real estate professionals
who meet the 500-hour safe harbor. There’s just one problem: this means
that you have to understand the final regulations.
That is my big takeaway from the instructions – there’s no faking it. When we
saw that this new, complex area of the law would ultimately be computed on a
one-page form, we anticipated that the meat of the computation would be
done off-form in worksheets provided by the instructions. And that’s exactly
what happened. But that shifts the onus back to us as tax advisors to
sure our inputs are correct, which means we must understand the nuances of
the final regulations.
Based on my review of the instructions, it will be virtually impossible for a tax
advisor to accurately compute, for example, the Net Gains and Losses
worksheet without a solid understanding of the types of gains and losses the
final regulations contemplate being included in and excluded from net
investment income. Perhaps I’m wrong, and the software will be idiot-proof,
but I wouldn’t count on it.
Real estate professionals
The final regulations provided a major boon to real estate professionals by
providing a safe-harbor whereby the taxpayer’s rental activity will be deemed
to rise to the level of a trade or business. Meeting the safe-harbor is vital,
because it effectively excludes the rental income from net investment income
because the income is rendered nonpassive – by virtue of the taxpayer’s real
estate professional status – and is deemed to be earned in a trade or business
by virtue of the safe harbor. You can read about it here.
Be warned, however – in the discussion on the safe harbor for real estate
professionals in the draft instructions, you will find the following language:
You qualify for the safe harbor if you are a real estate professional for
purposes of section 469 and you: Participate in each rental real estate activity
for more than 500 hours during the tax year, or Participated in a rental real estate activity for more than 500 hours in any 5 tax years (whether or not consecutive) during the 10 tax years immediately
prior to this tax year.
I underlined the text above because it would seem to indicate that a real estate
professional with 10 rentals must spend more than 500 hours on each rental
to enjoy the benefit of the safe-harbor. Remember, however, that a taxpayer is
permitted by Reg. Section 1.469-9 to elect to group all of his or her rental
activities together for purposes of meeting the real estate professional tests of
Section 469(c)(7). The final Section 1411 regulations make it clear that if this
election is made, the taxpayer need only spend 500 hours on the grouped
rental activities in order to satisfy the safe harbor. This is not made clear in the
draft instructions, but it is in fact the case. This greatly expands the reach of
the safe-harbor for taxpayers with multiple rentals.
Use of excess losses to of set other net investment income
Perhaps the most material change in the final regulations is the expansion of
the definition of “properly allocable deductions” to include any net losses from
the sale of property – or what I call “excess three little i losses” – to the extent
those losses are used in the current year to reduce the taxpayer’s taxable
income. This effectively permits certain excess losses from the disposition of
property to reduce other forms of net investment income like interest,
dividends, or passive income.
My first concern was mentioned above. The computation of the taxpayer’s net
gain or loss is driven by the completion of an off-form worksheet that will
require the taxpayer to be well versed in the concepts found in Reg. Section
1.1411-4. You can read about those concepts here.
Next, because the final regulations treat the excess losses as “properly
allocable deductions,” you may have expected to see those amounts appear in
Part II of the draft form alongside other allocable deductions like investment
interest expense or state and local taxes. Instead, the Form 8960 simply
allows Line 5d – the total of gains or losses included in net investment income
– to be negative.
Pre 2013 installment sales of S corporation stock or partnership
interests
Under newly published proposed regulations, a taxpayer who materially
participates in a trade or business conducted by an S corporation or
partnership will not include in net investment income any gain from the sale
of a membership interest in the corporation or partnership unless a deemed
sale of the assets of the entity would have yielded gain that would be included
in the taxpayer’s net investment income.
Also under those regulations, a taxpayer who sells the membership interest
on the installment basis must compute the amount of the gain to be included
in net investment income in the year of sale. Any amount of the gain that is
excluded from net investment income is added to the taxpayer’s basis in the
membership interest for purposes of computing the gross profit percentage
and resulting gain in subsequent years for purposes of determining net
investment income.
Assume A sells S Co. stock with a basis of $10,000 for $100,000, to be paid
$20,000 in the year of sale and in each of the next four years. Assume A opts
not to use the simplified method, and determines under the deemed asset sale
steps that $50,000 of the gain must be included in net investment income.
This means the “excluded gain” is $40,000 ($90,000 gain less $50,000
included in net investment income.)
A must increase his basis in the S Co. stock of $10,000 by the $40,000 of
excluded gain, bringing his basis to $50,000. This brings A’s basis for
purposes of the net investment income tax to $50,000, and his gross profit
percentage is 50%.
Each year, when A receives $20,000 on the installment note, for chapter 1
purposes he will recognize $18,000 of gain (gross profit percentage of 90% *
$20,000 cash). The amount included in net investment income, however,
would be only $10,000 (gross profit percentage of 50% * $20,000 cash).
Thus, over the five years, A would include $50,000 in net investment income,
and $40,000 would be excluded from net investment income.
Many tax advisors have wondered how this will impact taxpayers who sold a
membership interest prior to 2013, because Section 1411 was not in place at
that time. Did this mean that taxpayers were resigned to including the entire
amount of gain from per-2013 sales that is recognized in 2013 and beyond in
net investment income?
The regulations seemed to indicate that this was not the case, and the draft
instructions confirm this conclusion, providing:
If you disposed of a partnership interest or S corporation stock in an
installment sale transaction to which section 453 applies, you need to
calculate your adjustment to net gain in the year of the disposition, even if the
disposition occurred prior to 2013. The dif erence between the amount
reported for regular tax and NIIT will be taken into account when each
payment is received.
The instructions go on to explain that if you sold the membership interest
prior to 2013, in the first year you are subject to the net investment income tax
you are required to attach to your return a statement explaining your
computation of the excluded amount, as well as other required disclosures. In
addition, the worksheet on page 9 will walk you through a computation
whereby you first include in net investment income the current year gain
recognized under the installment method for income tax purposes before
backing out the amount excluded from net investment income as determined
in my example above.
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