Avoiding the Investment Surtax on Rental Income
The Section 1411 surtax and the real estate professional
Beginning with the 2013 tax year, Code Sec. 1411 imposes a 3.8% surtax on net investment income of designated high-income taxpayers. Net investment income may include rental income, but not if the rental activity constitutes a trade or business under general principles of tax law (Section 162) and the taxpayer eligible for qualified real estate professional status materially participates in the activity for the year in question. Existing case law is taxpayer-friendly with respect to trade-or-business status, even when the activity involves the rental of a single property. Taxpayers who can meet the threshold activity for a trade or business only through the efforts of agents will likely still be subject to the surtax because they will fail to satisfy one of the material participation tests. However, those who satisfy a material participation test should also be able to demonstrate sufficient activity to meet the trade-or-business standard of case law
SECTION 1411 SURTAX
THE SECTION 1411 SURTAX AND THE REAL ESTATE PROFESSIONAL
Property owners can avoid the 3.8% surtax on rental income by demonstrating that the rental activity constitutes a trade or business in which they materially participated.
Section 1411 imposes a 3.8% surtax on net investment income of high income taxpayers beginning with the 2013 tax year. For this purpose, high income is defined to be married filing joint with modified adjusted gross income (MAGI) in excess of $250,000 and single taxpayers with MAGI in excess of $200,000. New Form 8960 will be used to report sources of income subject to the surtax and to compute the additional tax due. The surtax applies to rental income unless that income is attributable to a trade or business that is not a passive activity with respect to the taxpayer. If applicable, the base for the tax is net investment income, which in the case of rent is the excess of the gross rent income over deductions properly allocable to production of that rent income. The surtax is part of the funding mechanism for the Affordable Care Act, and was estimated to raise $318 billion over the ten-year budget forecast for implementation of the health care act.
Section 469(c)(2) defines a passive activity to include any rental activity. However, Section 469(c)(7) exempts from the automatic passive classification a rental activity operated by a taxpayer who performs more than one-half of his or her service in Real property trade or businesses in which he materially participates during the year and who also performs more than 750 hours of service in such real property activities. These individuals are called qualified real estate professionals or less formally just “operators.” A rental activity operated by a qualifying individual does not escape passive classification, but is instead subject to the general rule of Section 469(c)(1)that the passive or active status is determined by whether the taxpayer materially participated in the activity during the year. Although each interest in a rental is generally treated as a separate activity, the operator’s ability to elect to aggregate rental interests as a single activity makes it more likely that the activity will escape classification as a passive activity.
In addition to the operator rule, there are several other exceptions to the automatic passive classification for rental activities. Unlike the operator rule, these exceptions are intended to be pro-government as they prevent classification of rent income as passive in situations in which the nature of the activity is likely to produce net rental income or gains from the disposition of the property. These exceptions include the rental of property to an activity in which the taxpayer materially participates (“self-charged” rent), the rental of certain nondepreciable property, and the rental of property incidental to development activities. Further, there are certain activities that may commonly be considered as rentals that are excluded from the definition of a “rental” and therefore from automatic passive status. Non-passive income or gains attributable to any of these excluded activities will nonetheless be subject to the Section 1411 surtax if the activity is not considered to be a trade or business with respect to the taxpayer.
The remainder of this article will focus on the qualified real estate professional and the ability to avoid the surtax by demonstrating both that the taxpayer materially participates with respect to the rental activity, and that the rental activity is a trade or business under general principles of tax law. The trade-or-business issue is expected to create the greatest concern among practitioners because it is an inherently factual determination. Qualified real estate professionals are likely to be the most affected by the trade-or-business issue because they often clear the material participation hurdle, leaving the trade-or-business issue as the impediment to avoiding the surtax. However, it should be understood that these issues also apply to taxpayers with rental activities that avoid automatic passive classification under one of the provisions noted above. Self-rental activities have generated the most questions in this regard. Proposed regulations interpreting the Section 1411 provisions were issued in December 2012 and final regulations were issued in November 2012, effective 12/2/13. The final regulations granted relief to self-charged rentals and also created a limited safe harbor for qualified real estate professionals.
Importance of trade-or-business classification
Many real estate operators will assume that if they are able to escape classification of their rental activities as passive, they will also escape the surtax. However, the statutory language clearly also requires that the rental activity be a trade or business with respect to the taxpayer to avoid the surtax. This was made clear in the preamble to the proposed regulations released in December 2012. The preamble states “a taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business (within the meaning of Section 162) with respect to the rental real estate activities.” This point is further emphasized by several other references in the preamble to both the proposed and final regulations, as well as in several examples in the regulations. One example in the proposed regulations simply states, as a factual matter and without analysis, that the rental of a commercial building “does not involve the conduct of a section 162 trade or business.” This example was retained in the final regulations, but added language indicating that the failure to qualify the activity as a trade or business was because the taxpayer failed to participate in the activity on a regular and continuous basis. If true, rental income from the building is subject to the surtax even if owned by a qualified real estate professional satisfying a material participation test. Tax planning for rental properties will involve substantially more analysis of the trade-or-business issue than is provided in the commercial building example.
Various provisions of the tax law use the term trade or business, including Sections 162, 1231, and 355. The preamble to the proposed regulations states that Section 162 offers the “most established definition” of a trade or business, and that the use of case law and administrative interpretations of the meaning of Section 162“facilitates administration of section 1411 and should simplify taxpayer compliance.” For this reason, Reg. 1.1411-1(d)(12) retains the rule of the proposed regulations that the existence of a trade or business will use the meaning of that term as established by Section 162. Commentators had asked for expanded guidance, perhaps including a bright-line test for trade-or-business status. However, the preamble to the final regulations notes that the status as a trade or business is based on a factual analysis and it is not possible to develop a bright-line definition by regulation.
Relief granted by the final regulations
The regulations offer two relief measures that address comments received on the proposed regulations. First, gross income from the rental of property to an entity in which the taxpayer materially participates is treated as non-passive. This is to prevent classification of the income as passive while the associated deduction is non-passive. If the income is not passive, the application of the surtax to the rent income turns on the status of the rental as a trade or business. Commentators felt that it was not fair to assess the surtax on income generated from an activity in which the lessor is, in substance, dealing with him or herself. In response, the final regulations deem income from a self-rental to be derived from an active trade or business. Second, many commentators noted that a real estate professional, by virtue of the level of work required to satisfy the definition, should be treated as engaged in a trade or business. Treasury noted in the preamble to the final regulations that the work required to satisfy the real estate professional test need not relate to rental properties. Further, satisfying the material participation test for an operator’s rentals may use one of the seven tests that does not require sufficient activity to justify treating the rental as a trade or business. To offer limited relief, the regulations adopt a safe harbor that treats the rental activities of the real estate professional as a trade or business if the operator satisfies the more-than-500-hour test for material participation, or meets the more-than-500-hour test for five of the ten preceding years. This test is applied to the aggregated rental activities elected by the real estate professional.
The qualified real estate professional safe harbor offers little meaningful relief, as existing case law would almost certainly classify an activity as a trade or business if the taxpayer’s activities rose to the level required to satisfy the safe harbor. Therefore, one is left with an analysis of existing judicial and administrative guidance with respect to the status of a rental as a Section 162 trade or business as the means of avoiding the surtax.
Rental operations as a Section 162 trade or business
The preamble to the proposed regulations states that the rules for determining a trade or business under Section 162 are “well established.” For anyone who has researched this issue, this is a surprising statement, as courts have tended to analyze individual facts and circumstances in a manner that would more likely lead to an “it depends” conclusion than a conclusion that the issue is well settled. The final regulations seem to be drafted with a more realistic assessment of the ability to define a trade or business. Moreover, as discussed below, it is well-established that a single rental property is a trade or business in cases in which the property is actually rented. Even unsuccessful efforts to rent the property have been held to be sufficient to qualify the activity as a trade or business, although the issue is less clear in such cases. This makes the conclusion in Reg. 1.1411-5(b)(3), Example 1, that the rental of a commercial building for $50,000 annual rent does not constitute a trade or business, surprising.
In response to criticism of this example when it was first introduced in the proposed regulations, the version in the final regulations adds an explanation that the taxpayer failed to participate in the activity on a regular and continuous basis. However, case law has adopted a surprisingly low level of required effort to qualify a single rental as a trade or business, and the modification of the language in the example is not likely to quell criticism of the example. Two examples that involve equipment leasing, exempt from classification as a rental activity because the average period of customer use is less than seven days, make the application of the surtax dependent on the taxpayer’s material participation because the examples simply state (again with no analysis) that the equipment leasing activity is a trade or business. While the regulations are not the place to provide an exhaustive analysis of the facts and circumstances used to establish trade-or-business status, the commercial building example suggests that the trade-or-business issue may be a focus of enforcement efforts with respect to rental real estate. The equipment leasing examples conclude that the activity is a trade or business, which is consistent with existing judicial and administrative interpretations. As noted below, however, those same interpretations have consistently held that rental of a single office building is, except for unusual fact patterns, also a trade or business.
It should also be noted that gains from disposition of a rental property may also be subject to the surtax if the taxpayer is passive with respect to the activity in which the property is held or if the activity is not a trade or business. Exposure to the surtax for gains from disposition may be a more significant issue than whether the surtax applies to net rental income because disposition would be expected to create a larger base for the surtax and also to increase the likelihood that the taxpayer’s MAGI will exceed the threshold in the year of disposition. An example in the regulations illustrating the application of the surtax to disposition of a rental property is similar to the commercial rental example described in the preceding paragraph. The property in question is a boat that has been rented by the taxpayer. The example states that the rental is a passive activity and is also not a trade or business with respect to the taxpayer, and then concludes that the surtax applies to gains from disposition of the boat because the activity is not a trade or business. However, the gain from disposition would also be subject to the surtax solely because of its status as a passive activity, even if it were a trade or business under Section 162. Thus, the example does not add any guidance to how the trade-or-business issue may be interpreted in connection with the Section 1411 surtax.
Before enactment of Section 1411, the need to qualify a rental activity as a trade or business arose most commonly in connection with the classification of the property as a capital asset or a Section 1231 asset.Section 1221(a)(2) excludes from the definition of a capital asset any real property used in a trade or business that is held for more than one year. Section 1231(b) includes such an asset in the definition of a Section 1231 asset. The taxpayer’s desire to satisfy the trade-or-business definition in this context may depend on whether the property is sold at a gain or a loss. Although net Section 1231 gains are classified as long-term capital gains, and are therefore generally subject to the same favorable tax rates as apply to such gains, the Section 1231(c)five-year lookback provision may cause certain net Section 1231 gains to be taxed at ordinary rates. Taxpayers subject to the lookback rule will prefer to classify rental property as a capital asset. If the sale produces a net loss, Section 1231(a)(2) states that the loss is not treated as a capital loss, so the annual limitation of $3,000 attributable to net capital losses will not apply. Taxpayers with losses from the sale of rental properties have had some success in arguing that even a single rental property can satisfy the threshold activity level of a trade or business.
In periods of rising real estate prices, the issue of whether a rental property is a trade or business typically does not arise, as gains from the sale of such assets are taxed at favorable rates whether the property is classified as a capital or a Section 1231 asset (again subject to the five-year lookback for net Section 1231 gains). However, many practitioners had to address the trade-or-business issue in recent years, as the economic downturn created opportunities for avoiding the $3,000 limitation on capital losses if a rental property was a trade-or-business asset. The issue also arose with respect to inherited rental property, as the Section 1014 basis adjustment coupled with expenses of sale tend to produce a loss when heirs sell the property. In many cases, the taxpayer’s only property holding was a single rental, raising the issue of whether a single rental could constitute a trade or business. This issue will be increasingly important as high-income taxpayers seek to avoid the surtax on gains arising from the sale of rental properties.
How well established is the trade-or-business issue for a rental?
As noted earlier, the preamble to the proposed regulations states “the rules under section 162 for determining the existence of a trade or business are well established.” The final regulations seem to take a less settled view of the issue, perhaps in response to comments received on the proposed regulations, but continue the use of the Section 162 standards as the appropriate definition of a trade or business. Unfortunately it remains unclear how the regulations incorporate existing judicial or administrative guidance, as examples provided generally state, as a factual matter, that a rental activity is not a trade or business, without offering any substantive analysis to support this conclusion. The preamble to the final regulations recognizes that case law often supports a single rental as a trade or business, but caution that Treasury does 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.” The preamble also states that taxpayer consistency will be evaluated, so a taxpayer who claims a single rental as a trade or business should also comply with Section 6041 reporting obligations in connection with that business. This is a reasonable statement, and many single-property landlords may not have payments subject to 1099 reporting. When applicable, however, the reporting obligation may dampen the enthusiasm of the taxpayer seeking to avoid the surtax on rent income net of allocable deductions by use of the trade-or-business argument.
As a general statement, the existence of a trade or business turns on the level of activity engaged in by the taxpayer. The Supreme Court has said “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity.” The Fifth Circuit had earlier adopted a similar view, stating that “the question is whether taxpayer has engaged in a sufficient quantum of focused activity to be considered to be engaged in a trade or business.” Assessing the level of a taxpayer’s activity is a factual question that does not lend itself to the conclusion that the determination is “well established.” Even the IRS has acknowledged this, stating that “the issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of the taxpayer’s activities, either personally or through agents….are so extensive as to rise to the stature of a trade or business.”
While the general definition of a trade or business turns on the level of a taxpayer’s activities, the courts, and the Tax Court in particular, have set a low bar to establish a rental activity as a trade or business. This has been helpful to taxpayers seeking Section 1231 loss treatment, and should become increasingly important for taxpayers satisfying the qualified real estate professional test or otherwise producing non-passive income from rents seeking to avoid the 3.8% surtax on net rental income or gains from disposition of the property. Before examining some of the relevant cases, it is important to first consider that the Section 1411 surtax issue is quite different from the Section 1231 loss issue in two respects. First, to have any concern that a surtax may be owed, the taxpayer must first have net income from the rental activity. The Section 1231 loss issue has arisen in a variety of scenarios, including less favorable fact patterns in which the property was held out for rental, but was not successfully rented, or situations in which the rental period was short and the amount of gross rent receipts was therefore low. Either of those situations would likely produce a net loss from the rental activity, and theSection 1411 surtax would not be a concern. Second, if the activity is automatically passive under Section 469(c)(2), rental income is subject to the surtax without regard to whether the rental activity constitutes a trade or business. It is only when the taxpayer qualifies as a real estate professional under Section 469(c)(7), or when the activity is exempt from rental classification under Temp. Reg. 1.469-1T(e)(3)(ii), that the issue of trade or business status becomes relevant. In both cases, the taxpayer must still show material participation in the activity before the status as a trade or business becomes relevant to escape the surtax. The activity needed to support material participation would also assist in trade-or-business classification, and that activity is generally absent in cases in which a rental activity was held to not rise to the level of a trade or business.
Thus, for the trade-or-business issue to be relevant to avoiding the Section 1411 surtax for rental income, the rental activity would require some period of regular rental at a price sufficient to produce net income for the issue to first arise, and the taxpayer would need to avoid automatic passive status, typically through classification as a qualified real estate professional, and then participate in the rental activity sufficiently to establish material participation. While the material participation tests do not directly link to the factors used to establish a trade or business, they do establish a pattern of regular and continuous activity with respect to the rental. This means that any judicial or administrative authorities that conclude that a rental is not a trade or business because of little or no rental activity, or little direct involvement by the taxpayer, may be troublesome in making the case for Section 1231 treatment, but should be factually distinguishable from situations in which the practitioner will need to contend that trade-or-business status is the final step to avoiding Section 1411 because the taxpayer materially participates in an activity producing net rental income. An analysis of existing judicial and administrative guidance for trade-or-business status for a rental property for purposes of Section 1411 will have that added benefit of material participation by the affected taxpayer.
In an early Tax Court case, Hazard, the taxpayer lived in a home in Kansas City for more than nine years before accepting a new job in Pittsburgh. He listed the Kansas City home for rent or sale in January 1940, and acquired a co-op property in Pittsburgh in February 1940. The Kansas City residence was rented from early 1940 to November 1943, at which time it was sold at a loss. The property had been listed for sale continuously during the rental period. While the facts do not state what level of participation the taxpayer had in the rental, it is unlikely that he was able to do much other than approve tenants and any management decisions made by an agent because he was living in Pittsburgh during the entire rental period. Nonetheless, the Tax Court concluded that the rental activity was a trade or business with respect to the taxpayer.
In Fegan, the taxpayer owned many real estate properties over the years, but the case dealt with a single motel property. Citing Hazard, the court affirmed its “longstanding definition of ‘trade or business’ as including under appropriate circumstances the rental of one property.” Because the definition of a trade or business always turns on factual issues, it is not surprising that the court used the limiting language “under appropriate circumstances,” a caveat made more clear in Curphey, a decision that gained significant attention at the time primarily for its implications for the home office deduction. In Curphey, the court again stated that it had repeatedly held that a single rental property could be a trade or business, but clarified that this was so based on a specific factual analysis rather than as a matter of law. The court noted that “the scope of the ownership and management activities may be an important consideration.”
While minimal activity does not seem fatal to the trade-or-business status of a rental, a short rental period or acquisition of property subject to an existing lease with no intent to continue to hold the property for rent beyond the existing lease period can be.
In fact, the Tax Court denied trade-or-business status to a property rented for a short period for minimal consideration, and the Second Circuit reached a similar conclusion when an inherited rental property continued to be leased to an existing tenant until a sale could be arranged. The seller did not make efforts to continue to lease the property and no maintenance activities were required during the ownership period. The Tax Court reached the same decision on similar facts, finding no trade or business for an inherited rental property that was held solely to sell, with no efforts to either continue lease activities or to actively manage the property. In Vandeyacht, the Tax Court found no trade or business when an investment property, which was also used as a vacation property, was occasionally rented to the taxpayer’s children and friends. The property was never rented for more than 12 weeks of a year and was not held out for rental to the general public.
It might be expected that the IRS would be more likely than the courts to conclude that rental of a single property did not rise to the level of a trade or business. However, the fact patterns of several rulings led the IRS to a conclusion that might also be expected had the Tax Court been the party adjudicating the issue. In TAM 8350008, a corporation was liquidated in 1938, and it distributed the right to receive payments under a long-term land lease to the shareholder. The land was used by the lessee to construct a hotel, and after the liquidation of the corporation, rent was paid to the shareholder-taxpayer from 1938 through 1974, at which time the hotel was closed and lease payments stopped. The taxpayer had done nothing but collect land lease payments during the time of ownership. The TAM concluded that the level of activity of the taxpayer could not support classification of the activity as a trade or business. This result seems to be both not surprising nor out of line with the conclusions reached by the Tax Court in similar fact patterns. Similarly, in Rev. Rul. 73-522, the IRS concluded that a nonresident alien had not established a U.S. trade or business with respect to net leased property when his only involvement was a single trip to the U.S. for the purpose of supervising negotiations for renewal of the lease. The IRS concluded that the taxpayer’s activities did not extend beyond mere ownership or receipt of income from an investment activity.
The lesson from the cases above seems to be that it is not necessary to engage in significant activities with respect to a single rental property to support trade-or-business status, most likely because such properties rarely require significant ongoing activities. However, it is necessary that whatever activities are typically required for the rental of such properties be conducted by the taxpayer or an agent. Thus, the result of the cases in which a single property is inherited subject to an existing lease and is thereafter held for the sole purpose of sale is not surprising. The taxpayer had no involvement in the activity of renting the property. The same is true for the IRS administrative guidance that found no trade or business when the taxpayer’s involvement was limited to little more than collecting rent checks. For the taxpayer to support a trade or business there should be some efforts to continue to hold the property for income-producing purposes and to handle any repair or maintenance work that may be required, either directly or through an agent. For example, a taxpayer who purchased a multi-unit property subject to existing leases was found to be conducting a trade or business when he personally sought new tenants as leases expired and arranged for repairs and maintenance as needed.
Applying existing guidance to the Section 1411 surtax issue
The preamble to the proposed regulations notes the large body of case law defining a trade or business for purposes of Section 162. To the extent the rules are, as the preamble states, “well established,” it is only that a factual analysis is required to determine the existence of a trade or business. The Supreme Court’s Groetzingerdecision requires taxpayer involvement with “continuity and regularity,” a standard not unlike the Fifth Circuit’s statement in Suburban Realty Corporation that the taxpayer must engage in a “sufficient quantum of focused activity” to justify classification as a trade or business. The willingness to accept a single rental as a trade or business is not surprising given the level of activity that would be expected to actively manage such a property. That is, because a single rental unit would not require a substantial amount of ongoing management responsibilities, a taxpayer who either personally or through an agent handles whatever is required has met the “sufficient quantum” standard. This is not unlike the Section 469 material participation standard of doing substantially all of the participation required by an activity, other than the material participation requirement is that the taxpayer handle such work personally rather than through an agent. The activity required to support a trade or business need not be traced to a particular individual.
The Section 1411 trade-or-business issue, as noted earlier, arises only when the rental activity produces net income and only when the taxpayer materially participates in the activity using the seven tests of Temp. Reg. 1.469-5T(a). The taxpayer must also avoid automatic passive classification, which may most commonly occur with a qualified real estate professional. Thus, when trade-or-business status is justified because the taxpayer has engaged one or more agents to handle all management-related activities for a rental property, the surtax would still be expected to apply because the taxpayer will be passive with respect to such activity. Although it remains unclear by what analysis Example 1 of Reg. 1.1411-5(b)(3) concludes that a commercial building rental activity is not a trade or business, the fact that the activity is stated to be passive with respect to the taxpayer (who presumably fails to qualify for the Section 469(c)(7) exception to Section 469(c)(2)) means that the status as a trade or business is not the critical issue in the example. The need to satisfy a material participation standard to support any argument that the rent income is not subject to the Section 1411 surtax makes it more likely that the rental will meet the threshold activity level established by the courts for trade-or-business status.
The frequent statements by the IRS in both the preamble and the examples of the proposed and final regulations, that the taxpayer’s rental activity may not be a trade or business, may well be valid taken by itself but become much less so when one considers the need to participate materially in the activity to avoid the surtax. In each of the cases and administrative holdings discussed in this article that found no trade or business for a single rental property, a common feature was little, and generally no, involvement by the taxpayer. In other cases, the rental period was very short or the rental income was negligible, both factors supporting no trade or business, but also factors that would not be expected to be found in cases in which the rental activity produces net rental income that might be subject to the surtax.
Conclusion
Beginning with the 2013 tax year, Section 1411 imposes a 3.8% surtax on net investment income of designated high-income taxpayers. Net investment income may include rental income, but not if the rental activity constitutes a trade or business under general principles of tax law (Section 162) and the taxpayer eligible for qualified real estate professional status materially participates in the activity for the year in question. Existing case law is taxpayer-friendly with respect to trade-or-business status, even when the activity involves the rental of a single property. Cases in which a single property could not satisfy the trade-or-business definition tend to involve no active efforts to rent the property on an ongoing basis or to manage needed repair and maintenance work (i.e., triple net lease property). The minimal rental effort fact patterns will not likely be the cause of significant Section 1411 effort because the net rental income will be zero or negative. The issue may arise with respect to gains from disposition of such property, but the lack of significant taxpayer effort would be expected to create surtax income from passive classification. Because the surtax can be avoided only when the taxpayer also materially participates in a rental business exempt from automatic passive status, it is expected that tax issues related to avoidance of the surtax by reliance on trade-or-business classification will present favorable fact patterns with respect to application of existing law defining a trade or business. Taxpayers who can meet the threshold activity for a trade or business only through the efforts of agents will likely still be subject to the surtax because they will fail to satisfy one of the material participation tests. However, those who satisfy a material participation test should also be able to demonstrate sufficient activity to meet the trade-or-business standard of case law.
