Other Interacting Provisions

One of them can make a taxable sale cheaper than an exchange. And one of them is an irrevocable election whose cost is measured in decades.

49.1 Net investment income tax

An individual is subject to a tax of 3.8 percent of the lesser of net investment income for the year or the excess of modified adjusted gross income over a threshold amount.¹ The threshold is $250,000 for a joint return or a surviving spouse, half that amount for a married taxpayer filing separately, and $200,000 in any other case.² Those figures are not indexed for inflation, which means the tax reaches steadily further each year.

Net investment income includes net gain, to the extent taken into account in computing taxable income, attributable to the disposition of property other than property held in a trade or business not described in the passive activity paragraph.³ A trade or business is described in that paragraph if it is a passive activity within the meaning of section 469 or a trade or business of trading in financial instruments or commodities.⁴

Two consequences follow for exchanges, and the first is favorable.

Deferred gain is not net investment income. Because the statute reaches net gain only to the extent taken into account in computing taxable income, gain deferred under section 1031 is outside the base. A fully deferred exchange defers the 3.8 percent along with the income tax, and the deferral is permanent where the endgame of Chapter 46 applies.

Recognized boot is net investment income, where the property was held in a passive activity. That produces the rate stacking described at 37.3. Boot falling in the unrecaptured section 1250 gain layer bears 25 percent under section 1(h) plus 3.8 percent here, for 28.8 percent federal before Maryland State and local income tax. A client told to expect a capital gains rate on a modest amount of boot has been told something that understates the cost by a wide margin.

The escape is not in section 1411 but in section 469. Gain from property held in a trade or business that is not passive is excluded from net investment income entirely. A taxpayer whose rental real estate escapes the per se passive rule, and in particular a real estate professional under the test examined at 49.2, may have recognized gain outside the base.

The practical instruction is that the net investment income question and the passive activity question are the same question. It is worth 3.8 percent of every dollar of recognized gain, and it should be answered from the client's actual hours and activities rather than assumed.

49.2 Passive activity losses and suspended losses

A passive activity includes any rental activity, without regard to whether the taxpayer materially participates, except as the real property business rule provides.⁵

The real property business rule. Where more than one half of the personal services the taxpayer performs in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the year in such businesses, the per se rule does not apply to the taxpayer's rental real estate activity. On a joint return, one spouse must separately satisfy both tests.⁶ Where the rule applies, each interest in rental real estate is a separate activity unless the taxpayer elects to treat all interests as one.⁷

A separate allowance permits a natural person who actively participates in rental real estate to offset up to $25,000 of loss, subject to a phase-out of fifty percent of the excess of adjusted gross income over a threshold.⁸

The rule that governs exchanges is in the disposition provision, and it is adverse. Suspended losses are released where the taxpayer disposes of an entire interest in a passive activity in a transaction in which all gain or loss realized on the disposition is recognized.⁹

A section 1031 exchange is not such a transaction. Suspended passive losses are not released, and they remain attached to the activity.

Four consequences, and they run in different directions.

The losses survive and follow the activity. A taxpayer who exchanges and continues the rental activity keeps the suspended losses available against passive income from that activity in later years. Nothing is lost.

Recognized boot may be sheltered by them. Boot recognized on an exchange of a passive rental property is passive income, and it enters the ordinary netting of passive income and loss for the year. A taxpayer with substantial suspended losses may recognize boot at no current cost. This is genuinely useful and frequently overlooked, and it is a reason not to contort a transaction to eliminate a modest amount of boot.

The entire interest requirement is a trap where activities are grouped. The release requires disposition of the taxpayer's entire interest in the activity. A taxpayer who elected to treat all rental real estate as a single activity cannot release losses by disposing of one property, however completely taxable that disposition is. The grouping election made years earlier controls.

A related party disposition does not release them. Where the taxpayer and the acquirer bear a relationship described in section 267(b) or section 707(b)(1), the release does not occur until the interest is acquired by a person not bearing that relationship.¹⁰

Two further rules matter at the ends of the holding period.

On an installment sale of an entire interest, the losses are released ratably in proportion to the gain recognized each year.¹¹ That interacts with Chapter 44: a failed exchange reported on the installment method releases suspended losses in the same proportion.

On death, the losses are allowed only to the extent they exceed the excess of the transferee's basis in the property over the decedent's adjusted basis immediately before death, and losses within that excess are not allowed as a deduction for any year.¹² In plain terms, the basis adjustment of Chapter 46 consumes the suspended losses dollar for dollar. A taxpayer who dies holding property with $400,000 of step-up and $300,000 of suspended losses loses the losses entirely. That is a real cost of the endgame and it is almost never mentioned when the strategy is presented.

The planning point that follows is a case for not exchanging. A taxpayer with large suspended losses and an appreciated property should compare two transactions rather than assuming the exchange is better.

A taxable sale recognizes the gain and releases the suspended losses, which may absorb most or all of it. The taxpayer pays little or no tax, receives cash, and if reinvested acquires property with a full cost basis and a fresh recovery period under Chapter 36 rather than the carryover basis and continued recovery period an exchange would produce.

An exchange defers the gain, keeps the losses suspended, and delivers a low basis property on a continued recovery period.

Where the suspended losses approximate the gain, the sale is frequently the better transaction, and it carries none of the deadline risk of Part VI. The comparison takes an hour and it is one of the few places in this work where the honest answer is to advise against an exchange.

49.3 Business interest limitation and the real property election

The deduction for business interest is limited to the sum of the taxpayer's business interest income, thirty percent of adjusted taxable income, and floor plan financing interest.¹³ Adjusted taxable income is computed without regard to any deduction allowable for depreciation, amortization, or depletion, among other items, which makes it an earnings measure before those deductions.¹⁴ Disallowed interest carries forward and is treated as business interest paid in the succeeding year.¹⁵

A small business exemption applies to a taxpayer meeting the gross receipts test of section 448(c), other than a tax shelter prohibited from using the cash method.¹⁶ Many individual real estate owners fall within it, and the question should be asked before the analysis goes further.

The election. For purposes of the limitation, the term trade or business does not include any electing real property trade or business.¹⁷ An electing real property trade or business is any trade or business described in the real property trade or business definition used in the passive activity rules that makes the election, and once made, the election is irrevocable.¹⁸

The price of the election is the alternative depreciation system, and this is where the provision reaches into Chapter 36. Nonresidential real property, residential rental property, and qualified improvement property held by an electing real property trade or business must be depreciated under that system.¹⁹ Under it, residential rental property has a recovery period of thirty years and nonresidential real property forty years, in place of twenty seven and a half and thirty nine.²⁰

The exchange consequence. The continuation rules of 36.2 determine the depreciation of exchanged basis by reference to the recovery period prescribed under section 168 for the properties. Where the electing business holds the replacement property, that prescribed period is the alternative system period, so the election lengthens the recovery of the exchanged basis and of the excess basis alike.

Because the election is irrevocable and attaches to the trade or business rather than to a property, a taxpayer who made it years ago and now acquires replacement property in an exchange holds that property in the electing business and must use the longer period for it. The decision made once governs every property the business acquires afterward.

The practical instruction is that the election should be modeled over the full expected holding period, including anticipated exchanges, before it is made. It trades a current interest deduction for a permanently slower depreciation deduction on every real property the business will ever hold, and there is no mechanism for revisiting it.

49.4 At-risk rules

For an individual and for certain closely held C corporations engaged in an activity to which the section applies, a loss from the activity is allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk for that activity at the close of the year.²¹ A loss disallowed for a year is treated as a deduction allocable to the activity in the first succeeding year.²²

The provision rarely binds in real estate practice, and the reason is a carve-out. Notwithstanding the general rules, in the case of an activity of holding real property a taxpayer is considered at risk with respect to the taxpayer's share of any qualified nonrecourse financing secured by real property used in the activity.²³

Qualified nonrecourse financing means financing borrowed by the taxpayer with respect to the activity of holding real property, borrowed from a qualified person or representing a loan from or guaranteed by a Federal, State, or local government, with respect to which no person is personally liable for repayment except as regulations provide, and which is not convertible debt.²⁴

Ordinary commercial mortgage financing on investment real estate generally satisfies that description, so the amount at risk includes the debt and the limitation does not bite. Where it does bite, the reason is usually one of three things: seller financing from a person with an interest in the activity other than as a creditor, financing from a related person that fails the qualified person requirement, or debt with conversion features.

The interaction with an exchange is minimal and should be stated so. Nothing in section 465 treats an exchange as a triggering event, and there is no analogue to the disposition rule that releases suspended passive losses. Amounts not at risk simply carry forward with the activity.

The ordering matters when losses are being computed. A loss must clear the taxpayer's basis in the activity, then the at-risk limitation of this section, then the passive activity limitation of 49.2, before it is deductible. A practitioner working through a client's suspended amounts should establish which limitation is actually binding before advising on a transaction designed to release them, because a sale that releases passive losses accomplishes nothing for amounts suspended under the at-risk rules.

Part IX closes with two chapters on partnership interactions and on creditors, insolvency, and bankruptcy, which take up the situations in which the taxpayer's own solvency or entity structure rather than the property determines the outcome.