Overview Of The New 3.8% Investment Income Tax, Part 3: Gains From The Sale Of Property (2024)

Today, we continue along our multiple-part journey through the new 3.8% net investment income tax regulations, an undertaking that is rapidly approaching a length that would make James Joyce uneasy.

As a reminder, beginning January 1, 2013, Section 1411 will impose upon taxpayers an additional 3.8% Medicare tax on the lesser of:

1.The taxpayer’s “net investment income,” or

2.The taxpayer’s “modified adjusted gross income” (if the taxpayer does not have foreign earned income excluded under Section 911, this will be identical to adjusted gross income)” less the “applicable threshold;” specifically:

•For married taxpayers filing jointly: $250,000.

•For married taxpayers filing separately: $125,000.

•For all other taxpayers: $200,000.

The definition of “net investment income” is first introduced in Prop. Reg. Section 1.1411-4(a)(1), which breaks those items constituting “net investment income” into three subparagraphs:

(i)Gross income from interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payment. (one little i income)

(ii)Other gross derived from a trade or business described in Prop. Reg. Section 1.1411-5 (two little i income); and

(iii) Net gain attributable to the disposition of property (three little i income).

In Part 1, we discussed the general application of Section 1411 and took a look at “one little i” income. In Part 2, we focused our attention on “two little i” income. So it follows that in today's Part3, we will be analyzing “three little i” income: net gain attributable to the disposition of property. So let’s get to it.

“Three Little i” Income, In General

If you’re particularly lonely astute, you may have noticed that our analysis of “one little i” income in Part 1 did not include capital gains. This is because all gains from the sale of property are covered separately under Prop. Reg. Section 1.1411-4(a)(1)(iii). Included within the purview of "three little i" income arelong-termand short-term capital gain, Section 1231 gain, Section 1245 ordinary income recapture, and unrecaptured Section 1250 gain. As seen with the previous two types of net investment income, however, the regulations provide a broad exception to the general rule of exclusion, which we’ll address shortly. But first, there’s some big-picture housekeeping to tend to.

1. The regulations define a “disposition” as a sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition. Importantly, however, gain that is deferred or excluded for income tax purposes is generally not taken into consideration for Section 1411 purposes until it is eventually included in taxable income, if ever.

For example, if a taxpayer transfers a piece of real estate in a like-kind exchange qualifying for deferral pursuant to Section 1031, then any gain deferred on the property is not included in net investment income until is eventually recognized under the Section 1031 rules.

In addition, if a taxpayers sells a principal residence and the gain is properly excludable under Section 121 because the taxpayer owned and used the home as their primary residence for two of the previous five years, then no gain from the sale of the home is included in “three little i” income. Consider the following example:

A sells a home that he has owned and used as his principal residence for five years and realizes $200,000 of gain on the sale. For income tax purposes, A is permitted to exclude the gain pursuant to Section 121. As a result, none of the $200,000 gain is included in A’s net investment income under “three little i.”

2. The reason gains from the sale of property are treated separately under the regulations is because they may be netted with losses from the sale of property; those losses, however, may not be used to offset “one little i” or “two little i” income. In addition, the regulations provide that losses from the sale of property may only reduce “three little i” gains to zero, they cannot generate a net loss that may be used to reduce other net investment income.

If a taxpayer has a net capital loss, the loss can reduce capital gain to zero, and just as the taxpayer can for income tax purposes under Section 1211, he or she may take a $3,000 net capital loss and use it to reduce other income. For investment income tax purposes, however, the taxpayer is limited to using the $3,000 net capital loss to offset other “three little i” gains, he or she cannot use the loss to offset, for example, interest income or passive income from a trade or business.

To illustrate:

During 2013, A recognizes a $10,000 capital gain, a $30,000 capital loss, $5,000 of Section 1231 gain, and $10,000 of interest. The $10,000 of interest is considered “one little i” income (See Part 1). In computing A’s “three little i” gain, A may reduce the $10,000 of capital gain by the $30,000 loss, but only to zero. A has a net capital loss of $20,000, of which $3,000 can be applied to reduce other “three little i” gains. Thus, A may reduce his $5,000 of Section 1231 gain to $2,000. The remaining $17,000 of net capital loss may be carried forward to reduce “three little i” gains in the future. No amount of the net capital loss may reduce A’s $10,000 of interest income.

Exclusion for Certain Gains

As mentioned above, there is a broad exclusion to the general rule that all gains from the sale of property constitute net investment income, and the standards for exclusion align with the principles we’ve established with regards to the exclusions from“one little i” and “two little i” income.

Gain from the sale of property will not be included in net investment income, if:

1. The property was held in a “trade or business” (see the discussion in Part 1),
2. The trade or businessis not the trade or business of trading in financial instruments, and
3. The trade or businessis not passive to the taxpayer (see the discussion in Part 2).

This exclusion has a dramatic effect on the owners of sole proprietorships, S corporations, or partnerships, as it may serve to remove a wide array of gains that, prior to the issuance of the proposed regulations, were anticipated to be included within net investment income. Consider the following example:

A owns 100% of an S corporation, S Co. S Co. is engaged in a trade or business that is not the trading of financial instruments, and A materially participates in the business. S Co. sells an asset used in its business, generating a $20,000 Section 1231 gain that is allocated to A on his Schedule K-1.

Because the $20,000 gain allocated to A washeld in a trade or business, thetrade or business was not the trading of financial instruments or commodities, and the activity is not passive to A, A may exclude the $20,000 gain from his “three little i” gains.

The regulations make it clear that this exclusion expands to cover gain from the sale of intangible assets, such as self-created goodwill, provided the goodwill was created by a trade or business that is neither the trading of financial instruments nor passive to the taxpayer. Prop. Reg. Section 1.1411-4 contains numerous examples that illustrate how to allocate goodwill among different lines of business, if necessary.

Special Treatment for the Sale of S Corporation Stock or Partnership Interests

Generally, the sale of stock in an S corporation or an interest in a partnership results in capital gain or loss. As a result, any resulting gain, barring an exception, would be included within “three little i” gain, and would not be eligible for the exclusion discussed above, as the stock or partnership interest was not “held within a trade or business.”

The proposed regulations, however, provide a special exclusion for owners of these flow-through entities at Prop. Reg. Section 1.1411-7. Unfortunately, however, these regulations do not provide a blanket exclusion, as seen with the other types of net investment income; rather, a series of time consuming, potentially complicated steps must be undertaken to determine how much, if any, of a shareholder’s or partner’s gain from the disposition of their ownership interest may be excluded from net investment income.

Each time a shareholder or partner sells an ownership interest giving rise to a gain, the regulations require the selling individual to undergo a five step process:

1. First, the shareholder or partner determines their gain on the sale of the membership interest under general income tax principles.
2. Next, the S corporation or partnership is treated as hypothetically selling all of its assets for cash equal to their respective fair market values immediate before the shareholder or partner sold their membership interest.
3. Then, gain or loss must be computed on each hypothetical sale of assets.
4. Next, the hypothetical gain or loss must be allocated to the selling shareholder or partner pursuant to Section 1366 (per-share/per-day) for an S corporation, and pursuant to the governing partnership agreement for a partnership.
5. Lastly, each hypothetical gain or loss allocated to the selling shareholder or partner must be analyzed to determine if it would be included within the member’s net investment income under “three little i” if it actually had been passed out on a Schedule K-1, or if it would be excluded by virtue of the fact that the gain or loss was 1) incurred within a trade or business, 2) the trade or business was not the trading of financial instruments, and 3) the activity was not passive to the taxpayer.

The taxpayer then adds up the hypothetical net gain that would have been excluded from net investment income if generated directly by the S corporation or partnership and allocated to the member. This positive number then reduces the amount of gain from the sale of the S corporation stock or partnership interest that the member must include within “three little i” income.

Obviously, the only way to drive home these principles is with a comprehensive example. And while the illustration may prove difficult to follow and ultimately frustrating, these little annoyances should get you prepared for the reality tax advisors face in 2013 and beyond:

A and B are shareholders of a dental practice, S Co., an S corporation. A owns 75% of the stock and materially participates in S Co. B owns the remaining 25% and does not materially participate in S Co.; he is a passive investor.

A sells his stock, which has a basis of $75,000, for $90,000, generating a capital gain of $15,000.

B sells his stock, which has a basis of $25,000, for $30,000, generating a capital gain of $5,000.

How much of A’s $15,000 and B’s $5,000 gain must each shareholder include in their net investment income under “three little i?”

Let’s quickly dispatch B from the equation. As a passive investor, all of B’s $5,000 gain will be included in net investment income, making an analysis of a hypothetical asset sale unnecessary.

A, however, is a different story. A materially participates in S Co., which means a portion of his $15,000 gain from the sale of stock may not be included in net investment income. To determine exactly how much, we have to go through the following five steps:

1. Determine A’s gain from the sale of stock: $15,000.
2. S Co. is deemed to undergo a hypothetical asset sale immediately before A sells his stock, in which S Co. receives cash for each asset equal to the asset’s fair market value. Assume that the total FMV of S Co.’s assets is $120,000. Thus, under Step 2, S Co. is deemed to have received $120,000 of cash.
3. S Co. must recognize gain or loss on the hypothetical sale of its assets. Assume the total basis in its assets is $100,000. Thus, S Co. would recognize $20,000 of gain on a hypothetical sale ($120,000 less $100,000).
4. S Co. must allocate to A his share of the $20,000 gain. Because A owns 75% of the stock, A is allocated $15,000 of gain under Section 1366.
5. Lastly, A must determine whether the $15,000 in hypothetical asset sale gain would have been included in A’s net investment income. While gain from the sale of property generally constitutes net investment income under “three little i,” because

• The properties were used in S Co.’s trade or business, a dental practice,
• The business was not the trading of financial instruments, and
• A materially participates in the activity, making it nonpassive to him

The $15,000 of gain allocated to A from the hypothetical asset sale would have been excluded from A’s net investment income. As a result, A is permitted to take this $15,000 of hypothetical gain and reduce his gain from the sale of the stock. Because A’s gain on the sale of the stock was $15,000, A is able to fully exclude the gain from net investment income ($15,000 - $15,000).

A couple of key limitations and observations:

• Things will not always work out so perfectly. For example, if A had acquired his stock through purchase and had a basis in his stock of $70,000 instead of $75,000, he would have recognized $20,000 of gain on the sale. Nothing changes inside the corporation, however, so the hypothetical asset sale gain allocated to A remains $15,000. Thus, A would be left with $5,000 of “three little i” gain ($20,000 - $15,000).
• If a seller generates a gain on the sale of the stock, this adjustment cannot create a net loss. It can only reduce the gain to zero. Nor can it create a larger gain.
• If a seller generates a loss on the sale of the stock, this adjustment cannot create a net gain, nor can it create a bigger loss.
• This required hypothetical asset sale will prove to be atremendous headache for tax advisors (and a boon to valuation experts). Now, each time a non-passive member sells an interest in an S corporation or a partnership, we will be required to look through the corporation or partnership, determine a fair market value of each asset, and run through these hypothetical calculations. Making matters worse, there really is no short cut available, as the proposed regulations require that we disclose on the tax return all of the steps indicated above. As you can imagine, this requirement raises a number of logistical and administrative challenges, for clients and tax advisors alike.
• What if a member sells an interest in an S corporation or partnership on the installment basis? The proposed regulations permit the taxpayer to compute their adjustment to the gain in the year of sale, and then each year as cash is received and gain recognized, reduce the gain by a prorate portion of the adjustment amount.
• But what if the stock or partnership interest was sold on the installment basis prior to 2013? Under the general rules, you’re out of luck: when the gain is recognized under the installment basis, you must include the gain in your net investment income in full, because the rules permitting an adjustment to the gain were not in place at the time of sale. The proposed regulations attempt to ameliorate this pain, however, by providing that if you sold a membership interest on the installment basis prior to 2013, you may elect to retroactively apply the adjustment rules provided for in Prop. Reg. Section 1.1411-7. While this sounds like a victory for taxpayers, it too carries with it a rather large administrative hurdle. Specifically, if you sold stock in, say,2007 on the installment basis and wish to elect to remove some or all of the gain from net investment income in 2013 and beyond, you have to retroactively compute the adjustment, which means you must determine the consequences of a deemed asset sale that would have occurred six years ago. Good luck with that.

We’ll be back with Part 4, in which we’ll discuss some additional considerations everyone should be aware of regarding the new net investment income tax.