On Nov. 26, 2013, the Internal Revenue Service (IRS) issued final regulations related to the Unearned Income Medicare Tax*, also known as 3.8 percent Medicare tax. Additionally, the IRS revoked the initial proposed regulations related to the net investment income calculation from the sale of S corporation stock or a partnership interest, and issued a new proposed regulation effective Dec. 2, 2013. The following is a brief summary of the key highlights of the proposed and final regulations, which are much more favorable for taxpayers than the previous rules.
Sale of S Corporation Stock or Partnership Interest
In December 2012, the IRS initially issued Proposed Regulation 1.1411.7 with regards to the sale of an individual’s share of S corporation stock or partnership interest. Under the proposed regulation, the taxpayer was required to go through a five-step process to determine the share of the gain that would be subject to the 3.8 percent Medicare tax. Due to the complexity of the calculation, the IRS revoked the regulation and issued a new proposed regulation that is to simplify the calculation of the gain subject 3.8 percent Medicare tax.
The new proposed regulation now utilizes a two-step process to determine the taxpayer’s share of gain that would be subject to the 3.8 percent Medicare tax. Step one is to determine the taxpayer’s share of the gain from a deemed asset sale of the company. The second step is to determine the gain from the portion of the assets that would be considered investment income. The amount of the gain subject to the 3.8 percent Medicare tax is the lessor of the seller’s overall gain from the sale of its membership interest “or” the seller’s share of the gain on assets that would be considered net investment income.
Real Estate Professionals
In general, if a taxpayer qualified as a real estate professional, then income from rental real estate activities would be considered non-passive income instead of passive income for income tax purposes. However, under the proposed regulations issued in December 2012, the rental real estate activities would be subject to the 3.8 Medicare tax if the activity was not considered a trade or business. At that time the IRS did not provide a bright line test for when an activity qualifies as a trade or business. Therefore, it was possible for a real estate professional to have some rental real estate income activities subjected to the 3.8 percent Medicare tax.
With the issuance of the final regulations, the IRS issued a safe harbor test that provides if a real estate professional participates in a rental real estate activity for more than 500 hours in the current year or in five of the previous 10 years, then the rental income associated with the activity will be presumed to be derived in the ordinary course of a trade or business. Additionally, if the real estate professional has elected to group their rental real estate activities as one activity under Treasury Regulation Section 1.469-9, then the 500-hour test will apply to the group instead of each individual activity.
Self-Rental Rules and Self-Charged Interest
In general rental real estate activities are considered passive with few exceptions. One of the exceptions relates to the self-rental rule. Treasury Regulation 1.469.2(f)(6) provides that if an individual rents property to an activity in which the individual is a material participant, any net rental income generated from the property is recharacterized as non-passive income. The purpose of this rule was to avoid the taxpayer from manipulating the income from the rental activity and offsetting it against passive losses.
With the issuance of the proposed regulation in December 2012, the IRS did not directly address the self-rental rule issue. The preamble to the proposed regulations stated that in order for a rental real estate activity not to be excluded from net investment income, it needs to be considered a trade or business activity. Additionally, the preamble stated that an allowable grouping of the rental real estate activity with the operating activity would not convert the rental real estate activity into a trade a business activity.
The final regulations issued by the IRS now provide that rental real estate activities subject to the recharacterization rules will be considered non-passive and therefore, not subject to the 3.8 percent Medicare tax. Also, if the rental real estate activity is grouped with an operating activity that qualifies as a trade or business, then the real estate activity will rise to the level of a trade or business activity and therefore, will not be subject to the 3.8 percent Medicare tax.
The regulations also addressed the issue of self-charged interest income treated as investment income. Self-charged interest occurs when an individual makes a loan to a pass-through entity which conducts a trade or business and the individual is a material participant in the entity. Under the proposed regulations, the interest income the individual received from the pass-through entity was considered net investment income and subject to the 3.8 percent Medicare tax. Under the final regulations, the individual is now allowed to offset the self-charged interest income against their share of the entity’s trade or business interest expense related to the loan from the individual. Any excess interest income will be considered investment income and subject to the 3.8 percent Medicare tax rules.
Treasury Regulation 1.469-4 allows for the taxpayer to treat two or more business activities or rental activities as a single activity if the activities constitute an appropriate economic unit (“AEU”). The grouping of activities as a single activity is based upon a facts and circumstances test. The grouping rules are important as it allows for the material participation rules to be applied to the group instead of each individual activity. There are certain limitations to the grouping rules and one limitation is a rental activity generally cannot be grouped with a trade or business activity.
With the issuance of the proposed regulations in December 2012, the IRS determined that taxpayers who meet the applicable income thresholds for the Unearned Income Medicare tax should have the opportunity to regroup their activities in the first taxable year beginning after Dec. 31, 2013. The final regulations still allow for the opportunity for eligible taxpayers to reconsider their groupings, but it may only occur during the first tax year beginning after Dec. 31, 2012. For calendar year taxpayers, it would be effective for the Dec. 31, 2013, tax year.
The final regulations also allow for a taxpayer to regroup their activities on an amended return – only if the taxpayer was not previously subjected to the Unearned Income Medicare Tax – but will now be subject to the tax as a result of the amended tax return. This is a one-time opportunity to regroup activities. Once the regrouping is complete, it would apply in all subsequent years.
Treatment of Losses to Offset Gains
Under the proposed regulations issued last December, losses from dispositions of property could only offset property dispositions gains. Losses in excess of gains could not be utilized to offset other investment income. The final regulations provide that in some limited cases excess losses may be available to offset other investment income.
With the issuance of these final regulations, planning opportunities should be taken advantage of prior to year-end. For more information, please contact your advisor.
*The Unearned Income Medicare Income Tax is applicable to taxpayers with investment income and their modified adjusted gross income is in excess of the following threshold amounts:
- Married Filing Joint or Surviving Spouses - $250,000
- Single and Head of Household - $200,000
- Married Filing Separate - $125,000