In a recent blog, we explained the ins and outs of net investment income (NIT) and net investment income tax (NIIT). That blog pointed out that under 26 U.S. Code § 1411 - “Imposition of Tax,” NIIT is generally assessed on investment income and entities (i.e., estates, trusts and individuals) with income higher than statutory threshold amounts.
Section 1411 also goes further, requiring a NIIT in certain trade or business activities. This is known as Section 1411 trade or business.
The “Trade or Business” Highlight
The IRS is pretty clear when it comes to defining “trade or business.” Specifically, trade or business focuses on “any activity carried on for the production of income from selling goods or performing services.” Do you manufacture widgets? That’s a trade or business. Do you service those widgets once they are sold? Again, a trade or business.
However, under the auspices of Section 1411, “trade or business” takes on an additional meaning. Specifically, the IRS indicates that “net investment income includes other gross income derived from a trade or business that’s a) a passive activity or b) a trade or business of trading in financial instruments or commodities.” Furthermore, selling that passive-income generating property or trading away that financial instrument creates net investment income. All of this falls under Section 1411 trade or business, and is subject to NIIT.
Not sure whether your particular activity is passive? Check out Section 469.
Explaining Section 469
This Section 469 discussion falls under IRC Title 26; specifically titled 26 U.S. Code § 469 – “Passive Activity Losses and Credits Limited.” Amid discussion about qualified entities and what is disallowed, the section indicates that passive activity focuses on anything involving the conduct of trade or business, in which a taxpayer doesn’t materially participate. Taking this concept one step further, material participation takes place if you’re involved with a business on “a regular, continuous and substantial basis.”
In other words, a business in which you aren’t necessarily hands on, which in most cases includes rental income or properties. There are exceptions like property that is actively used for a trade or business. If you run your widget manufacturing and distribution operations out of that property, that might be considered a hands-on operation. But for the most part, rental income from investment properties are considered passive investments. And, under Section 1411 trade or business, that income can be subject to net income investment tax.
Dealing with Taxation
One way to defer NIIT on the sale of your passive income-producing asset is to exchange it for a like-kind property via the 1031 exchange. There are also strategic methods used to lower your net investment income while you own the asset. Tax deferral strategies should be left to the discretion of your financial planner and/or tax expert.
The purpose of this article isn’t to dissuade you from passive investments. Rather, it’s to let you know that the earnings from the asset, as well as the capital gain from its sale, could be subject to taxation. Understanding the Section 1411 trade or business can help you be better prepared when it comes time to file taxes.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investors’ returns and may outweigh the tax benefits.
