(Continuation from previous blog post…)
Despite the previously discussed requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation. An exception to this default treatment is for real estate professionals, which will be discussed in my next blog post – Stay Tuned!
Would I make a grouping election? The passive versus nonpassive status is largely non elective and is generally determined by actual participation of the owner in the activity. A voluntary reduction or increase in time spent in certain activities by owners can serve to change the classification of an activity to or from a passive activity. Another way of voluntarily changing the classification is to make a make grouping election to treat a passive and nonpassive entity as one combined entity for purposes of meeting the material participation rules. This grouping election under Reg. Section 1.469-4 is for grouping one or more trade or business activities or rental activities as one single activity for purposes of meeting a material participation test. The grouped activities must constitute an appropriate economic unit. Factors that support this definition include:
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependencies between or among the activities
So, for example, if you wished to group two activities, one in which an owner materially participates and the other in which he does not, the grouped single activity will be treated as a material participation activity, or nonpassive, to the owner. However, there is an important limitation on grouping rental activities with other trade or business activities. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and
-The rental activity is insubstantial in relation to the trade or business activity;
-The trade or business activity is insubstantial in relation to the rental activity; or
-Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.
A grouping election under Reg. Section 1.469-4 must be reported on the tax return and the grouping cannot be changed in subsequent years unless the original grouping was inappropriate or a material change in facts and circumstances makes the grouping inappropriate. However, because the new net investment tax applies to activities which are passive, the regulations allow a “fresh start” for making a new grouping election starting in 2014, but a change to an existing grouping election can also be made in 2013 if the client is subject to the net investment tax in 2013.
Does the Net Investment Income Tax apply to a self-rental activity?
The self-rental rules were discussed frequently this tax prep season and given a fresh look because of their applicability to the new net investment income tax. If property is rented for use in a trade or business activity in which the taxpayer materially participates, the net income from the rental activity is considered a “self-rental” and that income is recharacterized as nonpassive. If the rental activity generates a net loss for the tax year, the income is not recharacterized and remains passive. Thus, the treatment can change from year to year. The treatment of the income or loss as nonpassive or passive retains the same character for net investment income tax purposes.
These questions will continue to be asked and examined for next filing season as we continue to get comfortable with the net investment tax. Although the rules are not new, they have definitely been brought to light due to the new tax and the necessity to determine an activity’s classification as passive or nonpassive. Of course, the above explanations are fairly general explanations for some very complicated tax areas that need to be read through thoroughly when dealing with these issues.