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Potential Pitfall in Net Investment Income Tax

Published: February 6th, 2013

Christopher R. D’Amico

It is a common planning tool for businesses that own real property used in their trade or business to own such real property in a separate entity (the “Real Estate Holding Company”), which has identical ownership to the entity that operates the trade or business (the “Operating Entity”).  Typically, the Operating Entity leases the real property from the Real Estate Holding Company on a “triple net” basis, and the Real Estate Holding Company has little actual business operations, other than holding the real property and collecting rent. 

In the regulations enacted under Section 469, which generally sets forth the passive activity loss rules, there is a “self charged rent” exception, which provides that any net income that passes through to those owners of the Real Estate Holding Company who materially participate in the Operating Entity is treated as active income for purposes of Code Section 469.   Treas. Reg. Section 1.469-2(f)(6).  It would make sense that the new Net Investment Income Tax (“NIIT”) [for more background on NIIT, see our previous post here], applying to “net investment income” of individuals with earnings in excess of $250,000 for joint filers ($125,000 for married taxpayers filing separately and $200,000 for all other filers), which includes activities that are “passive activities” with respect to the taxpayer under Code Section 469, would have a similar exception for “self charged rent.”    However, no such exception is covered in the Proposed Treasury Regulations under Code Section 1411, and the IRS has recently commented that it was an intentional omission from the Proposed Treasury Regulations. 

The IRS  has stated that for any rents received (or deemed received) by the taxpayer to be excluded from the definition of “net investment income” under Code Section 1411, the activity must be both non-passive and rise to the level of an active trade or business with respect to the taxpayer.   Clearly, under the “self charged rent” rule described above, any rental income of the Real Estate Holding Company passing through to its owners who materially participate in the Operating Entity’s active trade or business is not passive.   Whether the activities of the Real Estate Holding Company rise to the level of an active trade or business is a separate test, and under the traditional manner in which the typical Real Estate Holding Company rents the real property to the Operating Entity, under a triple net lease in which the Real Estate Holding Company performs minimal activities with respect to the property, it is unlikely that the activities of the Real Estate Holding Company would meet that threshold and constitute an active trade or business.   Even if the facts are such that those activities of the Real Estate Holding Company rise to the level of an active trade or business, that would not be the end of the story for the taxpayer, because, as the IRS interprets Code Section 1411, it would follow that taxpayer would also need to materially participate in that Real Estate Holding Company’s active trade or business as well in order for any such income to be exempt from the definition of “net investment income”.    

Unless and until the IRS changes its position or case law suggests otherwise, practitioners are going to need to re-examine existing Real Estate Holding Company structures and implement planning techniques (if available based on the facts) to limit or exclude the impact of the NIIT on those structures.   Some potential planning opportunities, whose efficacy will depend on the facts and circumstances of each particular taxpayer, include minimizing the amount of rent paid to the Real Estate Holding Company (in order to minimize the amount of rental income generated which is subject to the NIIT), not forming separate entities for the holding of real estate, and restructuring existing entities into some form of holding company structure.  Each of these alternatives will need to be carefully analyzed based upon the particular facts and circumstances of each situation, both as to existing Real Estate Holding Company structures and when setting up new Real Estate Holding Company structures.