Practice Areas

Final Net Investment Income Tax Regulations Adopt Taxpayer Friendly Rules for Self-Rental Income

December 3, 2013
Timothy M. Nichols

Timothy M. Nichols

As urged by commentators from this firm and elsewhere, the final regulations applying the new net investment income tax have adopted taxpayer-friendly rules regarding taxpayer “self-rental” arrangements.

Treasury Decision 9644

For liability and other reasons, taxpayers engaged in a trade or business will often separate their main trade or business activity and the real estate used in that trade or business into two separate entities.  In this arrangement the trade or business entity will often pay rent to the real estate entity in exchange for the use of the property.  The enactment of Code sec. 1411, which imposes a 3.8% tax on certain “net investment income” (“NII”) for tax years beginning after December 31, 2012, added an additional complication for taxpayers using these “self-rental” arrangements.   

The proposed regulations under Code sec. 1411 issued on November 30, 2012 left considerable uncertainty as to how self-rental arrangements would be treated for purposes of the NII tax.[1]  As highlighted by the American Bar Association Section of Taxation comments on the proposed regulations (Thomas J. Nichols, a shareholder of this firm, was one of the principal drafters of these comments), it was unclear in many circumstances whether self-rental income would be subject to the NII tax. 

The final regulations contained in Treasury Decision 9644 appear to reflect the recommendations of the commenters regarding self-rental income and provide relatively taxpayer-friendly guidance.   In particular, § 1.1411-4(g)(6) of the final regulations provides that self-rental income that is either described in Reg. § 1.469-2(f)(6) or generated by a rental activity appropriately grouped with a trade or business activity under Reg. § 1.469-4(d)(1) will be treated as derived in the ordinary course of a trade or business.  Such treatment effectively removes self-rental income from NII since income derived in the ordinary course of a trade or business is not subject to the NII tax.  Generally, under the final regulations, most taxpayers should be able to structure their self-rental arrangements to avoid paying NII tax on self-rental income.  However, given the complexity of the regulations under Code sec. 1411, taxpayers should consult with a tax advisor well-versed in these rules to ensure their exposure to this new tax is minimized. 

[1] See Thomas J. Nichols & Timothy M. Nichols, Self-Rental – Subject to Net Investment Income Tax?, CCH Journal of Passthrough Entities Choice of Entity Corner (March-April 2013).

TAX ADVICE LIMITATION:  To ensure compliance with the requirements of Circular 230, we inform you that any tax advice contained above is not intended or written to be used and cannot be used (i) by any taxpayer for the purpose of avoiding penalties that may otherwise be imposed under the Internal Revenue Code or (ii) by anyone for the purpose of promoting, marketing or recommending to another party any entity, investment plan or arrangement addressed herein.