New sec. 1411 brings difficulty defining real estate 'trade or business'.

• Author: Schwartzman, Randy A.

Effective for tax years beginning after Dec. 31, 2012, Sec. 1411 imposes an additional 3.8% tax on "net investment income" of individuals, trusts, and estates. The tax is imposed on the lesser of the net investment income amount or the excess of the taxpayer's modified adjusted gross income (MAGI) over a "threshold amount." For individuals, the threshold amount is $200,000 ($250,000 for joint filers and $125,000 for married individuals filing separately).

Net investment income, as defined in Sec. 1411(c) and Prop. Regs. Sec. 1.1411-4, encompasses portfolio income, such as interest, dividends, royalties, and capital gains, as well as income from the business of trading in financial instruments or commodities. The definition also includes rental income unless the income is derived in the ordinary course of a trade or business as defined in Sec. 162 and is not subject to the passive activity loss rules of Sec. 469.

Proposed Regs. Refer to Secs. 162 and 469

Proposed regulations under Sec. 1411 (REG-130507-11) provide that whether a taxpayer's activity is considered passive for purposes of the 3.8% tax is determined in accordance with the principles of Sec. 469, which deals with the disallowance of passive activity losses. In addition, the proposed regulations state that "trade or business" for purposes of Sec. 1411 has the same meaning as under Sec. 162, which permits deduction of ordinary and necessary expenses paid or incurred in carrying on a trade or business.

Trade or Business Under Sec. 162

Under Secs. 162(a) and 62(a)(1), a taxpayer's adjusted gross income is computed by deducting all ordinary and necessary expenses incurred in carrying on a trade or business. "Trade or business" in this context, however, has not been defined in. the Code, regulations, or IRS guidance. Thus, there are no uniform standards, and the determination whether a taxpayer's activities qualify as a trade or business is made on a case-by-case basis. Nonetheless, the preamble to the proposed regulations notes that "[t]he most established definition of trade or business is found under section 162(a). ... The use of the section 162 definition of trade or business facilitates administration of section 1411 and should simplify taxpayer compliance."

The Supreme Court has identified regularity (i.e., activity over a certain period) and a profit motive as factors that the courts have widely accepted as indicating the presence of a trade or business. The Court in...