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Net Investment Income Tax 3.8% - Definition of Net Investment Income
Net Investment Income Tax 3.8% – Definition of Net Investment Income
United States Code of Federal Regulations United States Code of Federal Regulations TITLE 26 C.F.R. — Internal Revenue CHAPTER I — INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY SUBCHAPTER A — INCOME TAX PART 1 — INCOME TAXES Net Investment Income TaxPage26 C.F.R. § 1.1411-4
Definition of net investment income. (a) In general. For purposes of section 1411 and the regulationsthereunder, net investment income means the excess (if any) of — (1) The sum of — (i) Gross income from interest, dividends, annuities, royalties, andrents, except to the extent excluded by the ordinary course of a trade orbusiness exception described in paragraph (b) of this section; (ii) Other gross income derived from a trade or business described in§ 1.1411-5; and (iii) Net gain (to the extent taken into account in computing taxableincome) attributable to the disposition of property, except to the extentexcluded by the exception described in paragraph (d)(4)(i)(A) of thissection for gain or loss attributable to property held in a trade orbusiness not described in § 1.1411-5; over (2) The deductions allowed by subtitle A that are properly allocable tosuch gross income or net gain (as determined in paragraph (f)of this section). (b) Ordinary course of a trade or business exception. Gross incomedescribed in paragraph (a)(1)(i) of this section is excluded from netinvestment income if it is derived in the ordinary course of a trade orbusiness not described in § 1.1411-5. See § 1.1411-6 for rules regardingworking capital. To determine whether gross income described in paragraph(a)(1)(i) of this section is derived in a trade or business, the followingrules apply. (1) In the case of an individual, estate, or trust that owns or engagesin a trade or business directly (or indirectly through ownership of aninterest in an entity that is disregarded as an entity separate from itsowner under § 301.7701-3), the determination of whether gross incomedescribed in paragraph (a)(1)(i) of this section is derived in a trade orbusiness is made at the individual, estate, or trust level. (2) In the case of an individual, estate, or trust that owns an interestin a passthrough entity (for example, a partnership or S corporation), andthat entity is engaged in a trade or business, the determination ofwhether gross income described in paragraph (a)(1)(i) of this section is — (i) Derived in a trade or business described in § 1.1411-5(a)(1) is madeat the owner level; and (ii) Derived in a trade or business described in § 1.1411-5(a)(2) ismade at the entity level. (3) The following examples illustrate the provisions of this paragraph(b). For purposes of these examples, assume that the taxpayer is a UnitedStates citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. Multiple passthrough entities. A, an individual, owns aninterest in UTP, a partnership, which is engaged in a trade or business.UTP owns an interest in LTP, also a partnership, which is not engaged in atrade or business. LTP receives $10,000 in dividends, $5,000 of which isallocated to A through UTP. The $5,000 of dividends is not derived in atrade or business because LTP is not engaged in a trade or business. Thisis true even though UTP is engaged in a trade or business. Accordingly,the ordinary course of a trade or business exception described inparagraph (b) of this section does not apply, and A’s $5,000 of dividendsis net investment income under paragraph (a)(1)(i) of this section. Example 2. Multiple passthrough entities. B, an individual, owns aninterest in UTP2, a partnership, which is not engaged in a trade orbusiness. UTP2 owns an interest in LTP2, also a partnership, which isengaged in a commercial lending trade or business. LTP2 is not engaged ina trade or business described in § 1.1411-5(a)(2). LTP2’s trade orbusiness is not a passive activity (within the meaning of section 469)with respect to B. LTP2 earns $10,000 of interest income from its trade orbusiness which is allocated to B through UTP2. Although UTP2 is notengaged in a trade or business, the $10,000 of interest income is derivedin the ordinary course of LTP2’s lending trade or business. Because LTP2is not engaged in a trade or business described in § 1.1411-5(a)(2) andbecause LTP2’s trade or business is not a passive activity with respect toB (as described in § 1.1411-5(a)(1)), the ordinary course of a trade orbusiness exception described in paragraph (b) of this section applies, andB’s $10,000 of interest is not included as net investment income underparagraph (a)(1)(i) of this section. Example 3. Entity engaged in trading in financial instruments. C, anindividual, owns an interest in PRS, a partnership, which is engaged in atrade or business of trading in financial instruments (as defined in §1.1411-5(a)(2)). PRS’ trade or business is not a passive activity (withinthe meaning of section 469) with respect to C. In addition, C is notdirectly engaged in a trade or business of trading in financialinstruments or commodities. PRS earns interest of $50,000, and C’sdistributive share of the interest is $25,000. Because PRS is engaged in atrade or business described in § 1.1411-5(a)(2), the ordinary course of atrade or business exception described in paragraph (b) of this sectiondoes not apply, and C’s $25,000 distributive share of the interest is netinvestment income under paragraph (a)(1)(i) of this section. Example 4. Application of ordinary course of a trade or businessexception. D, an individual, owns stock in S corporation, S. S is engagedin a banking trade or business (that is not a trade or business of tradingin financial instruments or commodities), and S’s trade or business is nota passive activity (within the meaning of section 469) with respect to Dbecause D materially participates in the activity. S earns $100,000 ofinterest in the ordinary course of its trade or business, of which $5,000is D’s pro rata share. For purposes of paragraph (b) of this section, theinterest income is derived in the ordinary course of S’s banking businessbecause it is not working capital under section 1411(c)(3) and §1.1411-6(a) (because it is considered to be derived in the ordinary courseof a trade or business under the principles of § 1.469-2T(c)(3)(ii)(A)).Because S is not engaged in a trade or business described in §1.1411-5(a)(2) and because S’s trade or business is not a passive activitywith respect to D (as described in § 1.1411-5(a)(1)), the ordinary courseof a trade or business exception described in paragraph (b) of thissection applies, and D’s $5,000 of interest is not included underparagraph (a)(1)(i) of this section. (c) Other gross income from a trade or business described in § 1.1411-5.For a trade or business described in § 1.1411-5, paragraph (a)(1)(ii) ofthis section includes all other gross income (within the meaning ofsection 61) that is not gross income described in paragraph (a)(1)(i) ofthis section or net gain described in paragraph (a)(1)(iii) of thissection. (d) Net gain. This paragraph (d) describes special rules for purposes ofparagraph (a)(1)(iii) of this section. (1) Definition of disposition. For purposes of section 1411 and theregulations thereunder, the term disposition means a sale, exchange,transfer, conversion, cash settlement, cancellation, termination, lapse,expiration, or other disposition (including a deemed disposition, forexample, under section 877A). (2) Limitation. The calculation of net gain may not be less than zero.Losses allowable under section 1211(b) are permitted to offset gain fromthe disposition of assets other than capital assets that are subject tosection 1411. (3) Net gain attributable to the disposition of property— (i) Generalrule. Net gain attributable to the disposition of property is the gaindescribed in section 61(a)(3) recognized from the disposition of propertyreduced, but not below zero, by losses deductible under section 165,including losses attributable to casualty, theft, and abandonment or otherworthlessness. The rules in subchapter O of chapter 1 and the regulationsthereunder apply. See, for example, § 1.61-6(b). For purposes of thisparagraph, net gain includes, but is not limited to, gain or lossattributable to the disposition of property from the investment of workingcapital (as defined in § 1.1411-6); gain or loss attributable to thedisposition of a life insurance contract; and gain attributable to thedisposition of an annuity contract to the extent the sales price of theannuity exceeds the annuity’s surrender value. (ii) Examples. The following examples illustrate the provisions of thisparagraph (d)(3). For purposes of these examples, assume that the taxpayeris a United States citizen, uses a calendar taxable year, and Year 1 andall subsequent years are taxable years in which section 1411 is in effect: Example 1. Calculation of net gain. (i) In Year 1, A, an unmarriedindividual, realizes a capital loss of $40,000 on the sale of P stock andrealizes a capital gain of $10,000 on the sale of Q stock, resulting in anet capital loss of $30,000. Both P and Q are C corporations. A has noother capital gain or capital loss in Year 1. In addition, A receiveswages of $300,000 and earns $5,000 of gross income from interest. Forincome tax purposes, under section 1211(b), A may use $3,000 of the netcapital loss against other income. Under section 1212(b)(1), the remaining$27,000 is a capital loss carryover. For purposes of determining A’s Year1 net gain under paragraph (a)(1)(iii) of this section, A’s gain of$10,000 on the sale of the Q stock is reduced by A’s loss of $40,000 onthe sale of the P stock. In addition, A may reduce net investment incomeby the $3,000 of the excess of capital losses over capital gains allowedfor income tax purposes under section 1211(b). (ii) In Year 2, A has a capital gain of $30,000 on the sale of Y stock.Y is a C corporation. A has no other capital gain or capital loss in Year2. For income tax purposes, A may reduce the $30,000 gain by the Year 1section 1212(b) $27,000 capital loss carryover. For purposes ofdetermining A’s Year 2 net gain under paragraph (a)(1)(iii) of thissection, A’s $30,000 gain may also be reduced by the $27,000 capital losscarryover from Year 1. Therefore, in Year 2, A has $3,000 of net gain forpurposes of paragraph (a)(1)(iii) of this section. Example 2. Calculation of net gain. The facts are the same as in Example1, except that in Year 1, A also realizes a gain of $20,000 on the sale ofRental Property D, all of which is treated as ordinary income undersection 1250. For income tax purposes, under section 1211(b), A may use$3,000 of the net capital loss against other income. Under section1212(b)(1) the remaining $27,000 is a capital loss carryover. For purposesof determining A’s net gain under paragraph (a)(1)(iii) of this section,A’s gain of $10,000 on the sale of the Q stock is reduced by A’s loss of$40,000 on the sale of the P stock. A’s $20,000 gain on the sale of RentalProperty D is reduced to the extent of the $3,000 loss allowed undersection 1211(b). Therefore, A’s net gain for Year 1 is $17,000 ($20,000gain treated as ordinary income on the sale of Rental Property D reducedby $3,000 loss allowed under section 1211). Example 3. Section 121(a) exclusion. (i) In Year 1, A, an unmarriedindividual, sells a house that A has owned and used as A’s principalresidence for the five years preceding the sale and realizes $200,000 ingain. In addition to the gain realized from the sale of A’s principalresidence, A also realizes $7,000 in long-term capital gain. A has a$5,000 short-term capital loss carryover from a year preceding theeffective date of section 1411. (ii) For income tax purposes, under section 121(a), A excludes the$200,000 gain realized from the sale of A’s principal residence from A’sYear 1 gross income. In determining A’s Year 1 adjusted gross income, Aalso reduces the $7,000 capital gain by the $5,000 capital loss carryoverallowed under section 1211(b). (iii) For section 1411 purposes, under section 121(a), A excludes the$200,000 gain realized from the sale of A’s principal residence from A’sYear 1 gross income and, consequently, from A’s net investment income. Indetermining A’s Year 1 net gain under paragraph (a)(1)(iii) of thissection, A reduces the $7,000 capital gain by the $5,000 capital losscarryover allowed under section 1211(b). Example 4. Section 1031 like-kind exchange. (i) In Year 1, A, anunmarried individual who is not a dealer in real estate, purchasesGreenacre, a piece of undeveloped land, for $10,000. A intends to holdGreenacre for investment. (ii) In Year 3, A enters into an exchange in which A transfersGreenacre, now valued at $20,000, and $5,000 cash for Blackacre, anotherpiece of undeveloped land, which has a fair market value of $25,000. Theexchange is a transaction for which no gain or loss is recognized undersection 1031. (iii) In Year 3, for income tax purposes, A does not recognize any gainfrom the exchange of Greenacre for Blackacre. A’s basis in Blackacre is$15,000 ($10,000 substituted basis in Greenacre plus $5,000 additionalcost of acquisition). For purposes of section 1411, A’s net investmentincome for Year 3 does not include any realized gain from the exchange ofGreenacre for Blackacre. (iv) In Year 5, A sells Blackacre to an unrelated party for $35,000 incash. (v) In Year 5, for income tax purposes, A recognizes capital gain of$20,000 ($35,000 sale price minus $15,000 basis). For purposes of section1411, A’s net investment income includes the $20,000 gain recognized fromthe sale of Blackacre. (4) Gains and losses excluded from net investment income— (i) Exceptionfor gain or loss attributable to property held in a trade or business notdescribed in § 1.1411-5— (A) General rule. Net gain does not include gainor loss attributable to property (other than property from the investmentof working capital (as described in § 1.1411-6)) held in a trade orbusiness not described in § 1.1411-5. (B) Special rules for determining whether property is held in a trade orbusiness. To determine whether net gain described in paragraph (a)(1)(iii)of this section is from property held in a trade or business — (1) A partnership interest or S corporation stock generally is notproperty held in a trade or business. Therefore, gain from the sale of apartnership interest or S corporation stock is generally gain described inparagraph (a)(1)(iii) of this section. However, net gain does not includecertain gain or loss attributable to the disposition of certain interestsin partnerships and S corporations as provided in § 1.1411-7. (2) In the case of an individual, estate, or trust that owns or engagesin a trade or business directly (or indirectly through ownership of aninterest in an entity that is disregarded as an entity separate from itsowner under § 301.7701-3), the determination of whether net gain describedin paragraph (a)(1)(iii) of this section is attributable to property heldin a trade or business is made at the individual, estate, or trust level. (3) In the case of an individual, estate, or trust that owns an interestin a passthrough entity (for example, a partnership or S corporation), andthat entity is engaged in a trade or business, the determination ofwhether net gain described in paragraph (a)(1)(iii) of this section fromsuch entity is attributable to — (i) Property held in a trade or business described in § 1.1411-5(a)(1)is made at the owner level; and (ii) Property held in a trade or business described in § 1.1411-5(a)(2)is made at the entity level. (C) Examples. The following examples illustrate the provisions of thisparagraph (d)(4)(i). For purposes of these examples, assume the taxpayeris a United States citizen, uses a calendar taxable year, and Year 1 andall subsequent years are taxable years in which section 1411 is in effect: Example 1. Gain from rental activity. A, an unmarried individual, rentsa boat to B for $100,000 in Year 1. A’s rental activity does not involvethe conduct of a section 162 trade or business, and under section469(c)(2), A’s rental activity is a passive activity. In Year 2, A sellsthe boat to B, and A realizes and recognizes taxable gain attributable tothe disposition of the boat of $500,000. Because the exception provided inparagraph (d)(4)(i)(A) of this section requires a trade or business, thisexception is inapplicable, and therefore, A’s $500,000 gain will be takeninto account under § 1.1411-4(a)(1)(iii). Example 2. Installment sale. (i) PRS, partnership for Federal income taxpurposes, operates an automobile dealership. B and C, unmarriedindividuals, each own a 40% interest in PRS and both materiallyparticipate in the activities of PRS for all relevant years. Therefore,with respect to B and C, PRS is not a trade or business described insection 1411(c)(2) and § 1.1411-5. D owns the remaining 20% of PRS.Assume, for purposes of this example, that PRS is a passive activity withrespect to D, and therefore is a trade or business described in section1411(c)(2)(A) and § 1.1411-5(a)(1). (ii)(A) In Year 0, a year preceding the effective date of section 1411,PRS relocates its dealership to a larger location. As a result of therelocation, PRS sells its old dealership facility to a real estatedeveloper in exchange for $1,000,000 cash and a $4,500,000 promissorynote, fully amortizing over the subsequent 15 years, and bearing adequatestated interest. PRS reports the sale transaction under section 453. PRS’sadjusted tax basis in the old dealership facility is $1,075,000. Assumefor purposes of this example that PRS has $300,000 of recapture income(within the meaning of section 453(i)); the buyer is not related to PRS,B, C, or D; and the buyer is not assuming any liabilities of PRS in thetransaction. (B) For chapter 1 purposes, PRS has realized gain on the transaction of$4,425,000 ($5,500,000 less $1,075,000). Pursuant to section 453(i), PRSwill take into account $300,000 of the recapture income in Year 0, and thegain in excess of the recapture income ($4,125,000) will be taken intoaccount under the installment method. For purposes of section 453, PRS’sprofit percentage is 75% ($4,125,000 gain divided by $5,500,000 grossselling price). In Year 0, PRS will take into account $750,000 of capitalgain attributable to the $1,000,000 cash payment. In the subsequent 15years, PRS will receive annual payments of $300,000 (plus interest). Eachpayment will result in PRS recognizing $225,000 of capital gain (75% of$300,000). (iii)(A) In Year 1, PRS receives a payment of $300,000 plus theapplicable amount of interest. For purposes of chapter 1, PRS recognizes$225,000 of capital gain. B and C’s distributive share of the gain is$90,000 each and D’s distributive share of the gain is $45,000. (B) The old dealership facility constituted property held in PRS’s tradeor business. In the case of section 453 installment sales, section 453governs the timing of the gain recognition, but does not alter thecharacter of the gain. See § 1.1411-1(a). The determination of whether thegain is attributable to the disposition of property used in a trade orbusiness described in paragraph (d)(4)(i) of this section constitutes anelement of the gain’s character for Federal tax purposes. As a result, theapplicability of paragraph (d)(4)(i) of this section is determined in Year0 and applies to all gain received on the promissory note during the 15year payment period. This result is consistent with the section 469determination of the passive or nonpassive classification of the gainunder § 1.469-2T(c)(2)(i)(A). (C) In the case of D, PRS’s trade or business is described in section1411(c)(2)(A) and § 1.1411-5(a)(1). Therefore, the exclusion in paragraph(d)(4)(i) of this section does not apply, and D must include the $45,000of gain in D’s net investment income. (D) In the case of B and C, PRS’s trade or business is not described insection 1411(c)(2) or § 1.1411-5. Therefore, B and C exclude the $90,000gain from net investment income pursuant to paragraph (d)(4)(i)of this section. (iv) In Year 2, C dies and C’s 40% interest in PRS passes to Estate. (v)(A) In Year 3, PRS receives a payment of $300,000 plus the applicableamount of interest. For purposes of chapter 1, PRS recognizes $225,000 ofcapital gain. B and Estate each have a distributive share of the gainequal to $90,000 and D’s distributive share of the gain is $45,000. (B) The calculation of net investment income for B and D in Year 3 isthe same as in (iii) for Year 1. (C) In the case of Estate, the distributive share of the $90,000 gainconstitutes income in respect of a decedent (IRD) under section 691(a)(4)and subchapter K. See § 1.1411-1(a). Assume that Estate paid estate taxesof $5,000 that were attributable to the $90,000 of IRD. Pursuant tosection 691(c)(4), the amount of gain taken into account in computingEstate’s taxable income in Year 3 is $85,000 ($90,000 reduced by the$5,000 of allocable estate taxes). Pursuant to section 691(a)(3) and §1.691(a)-3(a), the character of the gain to the Estate is the samecharacter as the gain would have been if C had survived to receive it.Although the amount of taxable gain for chapter 1 has been reduced, theremaining $85,000 retains its character attributable to the disposition ofproperty used in a trade or business described in paragraph (d)(4)(i) ofthis section. Therefore, Estate may exclude the $85,000 gain from netinvestment income pursuant to paragraph (d)(4)(i) of this section. (ii) Other gains and losses excluded from net investment income. Netgain, as determined under paragraph (d) of this section, does not includegains and losses excluded from net investment income by any otherprovision in §§ 1.1411-1 through 1.1411-10. For example, see § 1.1411-7(certain gain or loss attributable to the disposition of certain interestsin partnerships and S corporations) and § 1.1411-8(b)(4)(ii) (netunrealized appreciation attributable to employer securities realized on adisposition of those employer securities). (iii) Adjustment for capital loss carryforwards for previously excludedincome. [Reserved] (e) Net investment income attributable to certain entities— (1)Distributions from estates and trusts— (i) In general. Net investmentincome includes a beneficiary’s share of distributable net income, asdescribed in sections 652(a) and 662(a), to the extent that, undersections 652(b) and 662(b), the character of such income constitutes grossincome from items described in paragraphs (a)(1)(i) and (ii) of thissection or net gain attributable to items described in paragraph(a)(1)(iii) of this section, with further computations consistent with theprinciples of this section, as provided in § 1.1411-3(e). (ii) Distributions of accumulated net investment income from foreignnongrantor trusts to United States beneficiaries. [Reserved] (2) CFCs and PFICs. For purposes of calculating net investment income,additional rules in § 1.1411-10(c) apply to an individual, an estate, or atrust that is a United States shareholder that owns an interest in acontrolled foreign corporation (CFC) or that is a United States personthat directly or indirectly owns an interest in a passive foreigninvestment company (PFIC). (3) Treatment of income from common trust funds. [Reserved] (f) Properly allocable deductions— (1) General rule— (i) In general.Unless provided elsewhere in §§ 1.1411-1 through 1.1411-10, only properlyallocable deductions described in this paragraph (f) may be taken intoaccount in determining net investment income. (ii) Limitations. Any deductions described in this paragraph (f) inexcess of gross income and net gain described in section 1411(c)(1)(A) arenot taken into account in determining net investment income in any othertaxable year, except as allowed under chapter 1. (2) Properly allocable deductions described in section 62— (i)Deductions allocable to gross income from rents and royalties. Deductionsdescribed in section 62(a)(4) allocable to rents and royalties describedin paragraph (a)(1)(i) of this section are taken into account indetermining net investment income. (ii) Deductions allocable to gross income from trades or businessesdescribed in § 1.1411-5. Deductions described in section 62(a)(1)allocable to income from a trade or business described in § 1.1411-5 aretaken into account in determining net investment income to the extent thedeductions have not been taken into account in determining self-employmentincome within the meaning of § 1.1411-9. (iii) Penalty on early withdrawal of savings. Deductions described insection 62(a)(9) are taken into account in determining net investmentincome. (iv) Net operating loss. The total section 1411 NOL amount of a netoperating loss deduction allowed under section 172 is allowed as aproperly allocable deduction in determining net investment income for anytaxable year. See paragraph (h) of this section for the calculation of thetotal section 1411 NOL amount of a net operating loss deduction. (v) Examples. The following examples illustrate the provisions of thisparagraph (f)(2). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. (i) A, an individual, is a 40% shareholder in SCo, an Scorporation. SCo is engaged in a trade or business described in section1411(c)(2)(A). SCo is the only passive activity owned by A. In Year 1, SCoreported a loss of $11,000 to A which was comprised of gross operatingincome of $29,000 and operating deductions of $40,000. A’s at risk amountat the beginning of Year 1 is $7,000. There were no other events thataffected A’s at risk amount in Year 1. (ii) For purposes of calculating A’s net investment income, A’s $29,000distributive share of SCo’s gross operating income is income within themeaning of section 1411(c)(1)(A)(ii). (iii) As a result of A’s at risk limitation, for chapter 1 purposes, Amay only deduct $7,000 of the operating deductions in excess of the grossoperating income. The remaining $4,000 deductions are suspended becauseA’s amount at risk at the end of Year 1 is zero. (iv) For purposes of section 469, A has passive activity gross income of$29,000 and passive activity deductions of $36,000 ($40,000 of operatingdeductions allocable to A less $4,000 suspended under section 465).Because A has no other passive activity income from any other source,section 469 limits A’s passive activity deductions to A’s passive activitygross income. As a result, section 469 allows A to deduct $29,000 of SCo’soperating deduction and suspends the remaining $7,000. (v) For purposes of calculating A’s net investment income, A has $29,000of properly allocable deductions allowed by section 1411(c)(1)(B) andparagraph (f)(2)(ii) of this section. Example 2. (i) Same facts as Example 1. In Year 2, SCo reported netincome of $13,000 to A, which was comprised of gross operating income of$43,000 and operating deductions of $30,000. There were no other eventsthat affected A’s at risk amount in Year 2. (ii) For purposes of calculating A’s net investment income, A’s $43,000distributive share of gross operating income is income within the meaningof section 1411(c)(1)(A)(ii). (iii) Pursuant to section 465(a)(2), A’s deductions attributable to thegross income of SCo include the $30,000 deduction allocable to A in Year 2plus the $4,000 loss that was suspended and carried over to Year 2 fromYear 1 pursuant to section 465(a)(2). Under section 465(a)(2), the $4,000of losses from Year 1 are treated as deductions from the activity in Year2. As a result, A net operating income from SCo in Year 2 is $9,000($43,000-$30,000-$4,000) in Year 2. A’s amount at risk at the end of Year2 is $9,000. (iv) For purposes of section 469, A has passive activity gross income of$43,000. A’s passive activity deductions attributable to SCo are the sumof the Year 2 operating deductions allocable to A from S ($30,000),deductions formerly suspended by section 465 ($4,000), and passiveactivity losses suspended by section 469 ($7,000). Therefore, in Year 2, Ahas passive activity deductions of $41,000. Because A’s passive activitygross income exceeds A’s passive activity deductions, section 469 does notlimit any of the deductions in Year 2. At the end of Year 2, A has nosuspended passive activity losses. (v) Although A’s distributive share of Year 2 deductions allocable toSCo’s operating income was $30,000; the operative provisions of sections465 and 469 do not change the character of the deductions when suchamounts are suspended under either section. Furthermore, section 465(a)(2)and §§ 1.469-1(f)(4) and 1.469-2T(d)(1) treat amounts suspended from prioryears as deductions in the current year. See § 1.1411-1(a). Therefore, forpurposes of calculating A’s net investment income, A has $41,000 ofproperly allocable deductions allowed by section 1411(c)(1)(B) andparagraph (f)(2)(ii) of this section. (3) Properly allocable deductions described in section 63(d). Indetermining net investment income, the following itemized deductions aretaken into account: (i) Investment interest expense. Investment interest (as defined insection 163(d)(3)) to the extent allowed under section 163(d)(1). Anyinvestment interest not allowed under section 163(d)(1) is treated asinvestment interest paid or accrued by the taxpayer in the succeedingtaxable year. The following example illustrates the provisions of thisparagraph. For purposes of this example, assume that the taxpayer uses acalendar taxable year, and Year 1 and all subsequent years are taxableyears in which section 1411 is in effect: (A) In Year 1, A, an unmarried individual, pays interest of $4,000 ondebt incurred to purchase stock. Under § 1.163-8T, this interest isallocable to the stock and is investment interest within the meaning ofsection 163(d)(3). A has no investment income as defined by section163(d)(4). A has $10,000 of income from a trade or business that is apassive activity (as defined in § 1.1411-5(a)(1)) with respect to A. Forincome tax purposes, under section 163(d)(1), A may not deduct the $4,000investment interest in Year 1 because A does not have any section163(d)(4) net investment income. Under section 163(d)(2), the $4,000investment interest is a carryforward of disallowed interest that istreated as investment interest paid by A in the succeeding taxable year.Similarly, for purposes of determining A’s Year 1 net investment income, Amay not deduct the $4,000 investment interest. (B) In Year 2, A has $5,000 of section 163(d)(4) net investment income.For both income tax purposes and for determining section 1411 netinvestment income, A’s $4,000 carryforward of interest expense disallowedin Year 1 may be deducted in Year 2. (ii) Investment expenses. Investment expenses (as defined insection 163(d)(4)(C)). (iii) Taxes described in section 164(a)(3). Taxes imposed on incomedescribed in section 164(a)(3) that are allocable to net investment incomepursuant to paragraph (g)(1) of this section. Foreign income, war profits,and excess profits taxes are allowable as deductions under section164(a)(3) in determining net investment income only if the taxpayer doesnot choose to take any foreign tax credits under section 901 with respectto the same taxable year. See section 275(a)(4). For rules applicable torefunds of taxes described in this paragraph, see paragraph (g)(2) of thissection. (iv) Items described in section 72(b)(3). In the case of an amountallowed as a deduction to the annuitant for the annuitant’s last taxableyear under section 72(b)(3), such amount is allowed as a properlyallocable deduction in the same taxable year if the income from theannuity (had the annuitant lived to receive such income) would have beenincluded in net investment income under paragraph (a)(1)(i) of thissection (and not excluded from net investment income by reason of §1.1411-8). (v) Items described in section 691(c). Deductions for estate andgeneration-skipping taxes allowed by section 691(c) that are allocable tonet investment income; provided, however, that any portion of the section691(c) deduction described in section 691(c)(4) is taken into accountinstead in computing net gain under paragraph (d) and not under thisparagraph (f)(3)(v). (vi) Items described in section 212(3). Amounts described in section212(3) and § 1.212-1(l) to the extent they are allocable to net investmentincome pursuant to paragraph (g)(1) of this section. (vii) Amortizable bond premium. A deduction allowed under section171(a)(1) for the amortizable bond premium on a taxable bond (for example,see § 1.171-2T(a)(4)(i)(C) for the treatment of a bond premiumcarryforward as a deduction under section 171(a)(1)). (viii) Fiduciary expenses. In the case of an estate or trust, amountsdescribed in § 1.212-1(i) to the extent they are allocable to netinvestment income pursuant to paragraph (g)(1) of this section. (4) Loss deductions— (i) General rule. Losses described in section 165,whether described in section 62 or section 63(d), are allowed as properlyallocable deductions to the extent such losses exceed the amount of gaindescribed in section 61(a)(3) and are not taken into account in computingnet gain by reason of paragraph (d) of this section. (ii) Examples. The following examples illustrate the provisions of thisparagraph (f)(4). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. (i) A, an unmarried individual, owns an interest in PRS, apartnership for Federal income tax purposes. PRS is engaged in a tradingbusiness described in section 1411(c)(2)(B) and § 1.1411-5(a)(2) and hasmade a valid and timely election under section 475(f)(2). A’s distributiveshare from PRS in Year 1 consists of $125,000 of interest and dividendsand $60,000 of ordinary losses from the trading business. In addition toA’s investment in PRS, A sold undeveloped land in Year 1 for a long-termcapital gain of $50,000. A has no capital losses carried over from apreceding year. (ii) For purposes of chapter 1, A includes the $125,000 of interest anddividends, $60,000 of ordinary loss, and $50,000 of long-term capital gainin the computation of A’s adjusted gross income. (iii) For purposes of calculating net investment income, A includes the$125,000 of interest and dividends. Pursuant to paragraph (d) of thissection, A takes into account the $60,000 ordinary loss from PRS and the$50,000 of long-term capital gain in the computation of A’s net gain. A’slosses ($60,000) exceed A’s gains ($50,000). Therefore, A’s net gain underparagraph (d) of this section is zero. Additionally, A is allowed adeduction under paragraph (f)(4)(i) of this section for $10,000 (theamount of ordinary losses that were allowable under chapter 1 in excess ofthe amounts taken into account in computing net gain). A’s net investmentincome in Year 1 is $115,000. Example 2. (i) In Year 1, T, a nongrantor trust, incurs a capital lossof $5,000 on the sale of publicly traded stocks. In addition, T receives$17,000 of interest and dividend income. T has no capital losses carriedover from a preceding year. (ii) For purposes of chapter 1, T includes the $17,000 of interest anddividends and only $3,000 of the capital loss in the computation ofadjusted gross income. The remaining $2,000 capital loss is carried overto Year 2. (iii) For purposes of calculating net investment income, T includes the$17,000 of interest and dividends in net investment income. Pursuant toparagraph (d) of this section, T takes into account the $3,000 capitalloss allowed by chapter 1. T’s losses ($3,000) exceed T’s gains ($0).Therefore, T’s net gain under paragraph (d) of this section is zero.However, T is allowed a deduction under paragraph (f)(4)(i) of thissection for $3,000 (the amount of losses that were allowable under chapter1 in excess of the amounts taken into account in computing net gain). T’snet investment income in Year 1 is $14,000. Example 3. (i) In Year 1, B, an unmarried individual, incurs ashort-term capital loss of $15,000 on the sale of publicly traded stocks.B also receives annuity income of $50,000. In addition, B disposes ofproperty used in his sole proprietorship (which is not a trade or businessdescribed in section 1411(c)(2) or § 1.1411-5(a) for a gain of $21,000.Pursuant to section 1231, the gain of $21,000 is treated as a long-termcapital gain for purposes of chapter 1. B has no capital losses carriedover from a preceding year. (ii) For purposes of chapter 1, B includes the $50,000 of annuity incomein the computation of adjusted gross income. The $21,000 long-term capitalgain is offset by the $15,000 short-term capital loss, so B includes$6,000 of net long-term capital gain in the computation of adjusted grossincome. (iii) For purposes of calculating net investment income, B includes the$50,000 of annuity income in net investment income. Pursuant to paragraph(d)(4)(i) of this section, B’s net gain does not include the $21,000long-term capital gain because it is attributable to property held in B’ssole proprietorship (a nonpassive activity). Pursuant to paragraph (d) ofthis section, T takes into account the $15,000 capital loss allowed bychapter 1. B’s losses ($15,000) exceed B’s gains ($0). Therefore, A’s netgain under paragraph (d) of this section is zero. However, B is allowed adeduction under paragraph (f)(4)(i) of this section for $15,000 (theamount of losses that were allowable under chapter 1 in excess of theamounts taken into account in computing net gain). B’s net investmentincome in Year 1 is $35,000. (5) Ordinary loss deductions for certain debt instruments. An amounttreated as an ordinary loss by a holder of a contingent payment debtinstrument under § 1.1275-4(b) or an inflation-indexed debt instrumentunder § 1.1275-7(f)(1). (6) Other deductions. Any other deduction allowed by subtitle A that isidentified in published guidance in the Federal Register or in theInternal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) asproperly allocable to gross income or net gain under this section. (7) Application of limitations under sections 67 and 68. Any deductionsdescribed in this paragraph (f) that are subject to section 67 (the2-percent floor on miscellaneous itemized deductions) or section 68 (theoverall limitation on itemized deductions) are allowed in determining netinvestment income only to the extent the items are deductible for chapter1 purposes after the application of sections 67 and 68. For this purpose,section 67 applies before section 68. The amount of deductions subject tosections 67 and 68 that may be deducted in determining net investmentincome after the application of sections 67 and 68 is determined asdescribed in paragraph (f)(7)(i) and (f)(7)(ii) of this section. (i) Deductions subject to section 67. The amount of miscellaneousitemized deductions (as defined in section 67(b)) tentatively deductiblein determining net investment income after applying section 67 (but beforeapplying section 68) is the lesser of: (A) The portion of the taxpayer’s miscellaneous itemized deductions(before the application of section 67) that is properly allocable to itemsof income or net gain included in determining net investment income, or (B) The taxpayer’s total miscellaneous itemized deductions allowed afterthe application of section 67, but before the application of section 68. (ii) Deductions subject to section 68. The amount of itemized deductionsallowed in determining net investment income after applying sections 67and 68 is the lesser of: (A) The sum of the amount determined under paragraph (f)(7)(i) of thissection and the amount of itemized deductions not subject to section 67that are properly allocable to items of income or net gain included indetermining net investment income, or (B) The total amount of itemized deductions allowed after theapplication of sections 67 and 68. (iii) Itemized deductions. For purposes of paragraph (f)(7)(ii),itemized deductions do not include any deduction described in section68(c). (iv) Example. The following example illustrates the provisions of thisparagraph (f)(7). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: (A) A, an unmarried individual, has adjusted gross income in Year 1 asfollows:Wages $1,600,000Interest income 400,000Adjusted gross income 2,000,000 In addition, A has the following items of expense qualifying as itemizeddeductions:Investment expenses $70,000Job-related expenses 30,000Investment interest expense 75,000State income taxes 120,000 A’s investment expenses and job-related expenses are miscellaneousitemized deductions. In addition, A’s investment interest expense andinvestment expenses are properly allocable to net investment income(within the meaning of this section). A’s job-related expenses are notproperly allocable to net investment income. Of the state income taxexpense, A applied a reasonable method pursuant to paragraph (g)(1) ofthis section to properly allocate $20,000 to net investment income. (B) A’s 2-percent floor under section 67 is $40,000 (2% of $2,000,000).For Year 1, assume the section 68 limitation starts at adjusted grossincome of $200,000. The section 68 overall limitation disallows $54,000 ofA’s itemized deductions that are subject to section 68 (3% of the excessof the $2,000,000 adjusted gross income over the $200,000 limitationthreshold). (C) (1) A’s total miscellaneous itemized deductions allowable before theapplication of section 67 is $100,000 ($70,000 in investment expenses plus$30,000 in job-related expenses), and the total miscellaneous deductionsallowed after the application of section 67 is $60,000 ($100,000 minus$40,000). (2) The amount of the miscellaneous itemized deductions properlyallocable to net investment income after the application of section 67 is$60,000 (the lesser of $70,000 in investment expenses that are deductibleas a miscellaneous itemized deduction and properly allocable to netinvestment income or $60,000 of miscellaneous itemized deductionsallocable to net investment income allowed after the application ofsection 67). (D) (1) The amount of itemized deductions allocable to net investmentincome after applying section 67 to deductions that are also miscellaneousitemized deductions but before applying section 68 is $155,000. Thisamount is the sum of $60,000 of miscellaneous itemized deductionsdetermined in (C)(2), plus $20,000 in state income tax properly allocableto net investment income, plus $75,000 of investment interest expense.However, under section 68(c)(2), the $75,000 deduction for investmentinterest expenses is not subject to the section 68 limitation on itemizeddeductions and is excluded from the computation under § 1.1411-4(f)(7).Thus, the amount of itemized deductions allocable to net investment incomeand subject to section 68, after applying section 67 but before applyingsection 68, is $80,000. (2) A’s total itemized deductions allowed subject to the limitationunder section 68 and after application of section 67, but before theapplication of section 68, are the following:Miscellaneous itemized deductions $60,000State income tax 120,000Deductions subject to section 68 180,000 (3) Of A’s itemized deductions that are subject to the limitation undersection 68, the amount allowed after the application of section 68 is$126,000 ($180,000 minus the $54,000 disallowed in (B)). (E) Under paragraph (f)(7)(ii) of this section, the amount of itemizeddeductions allowed in determining net investment income after applyingsections 67 and 68 is the lesser of $80,000 (the sum of $60,000 determinedunder paragraph (C)(2) and $20,000 state income tax allocable to netinvestment income) or $126,000 (determined under (D)(3)). Therefore, A’sitemized deductions that are properly allocable to net investment incomeare $155,000 ($80,000 of properly allocable itemized deductions subject tosection 67 or 68 plus $75,000 of investment interest expense (which is notsubject to either section 67 or section 68 limitations)). (g) Special rules— (1) Deductions allocable to both net investmentincome and excluded income. In the case of a properly allocable deductiondescribed in section 1411(c)(1)(B) and paragraph (f) of this section thatis allocable to both net investment income and excluded income, theportion of the deduction that is properly allocable to net investmentincome may be determined by taxpayers using any reasonable method.Examples of reasonable methods of allocation include, but are not limitedto, an allocation of the deduction based on the ratio of the amount of ataxpayer’s gross income (including net gain) described in § 1.1411-4(a)(1)to the amount of the taxpayer’s adjusted gross income (as defined undersection 62 (or section 67(e) in the case of an estate or trust)). In thecase of an estate or trust, an allocation of a deduction pursuant to rulesdescribed in § 1.652(b)-3(b) (and § 1.641(c)-1(h) in the case of an ESBT)is also a reasonable method. (2) Recoveries of properly allocable deductions— (i) General rule. If ataxpayer is refunded, reimbursed, or otherwise recovers any portion of anamount deducted as a section 1411(c)(1)(B) properly allocable deduction ina prior year, and such amount is not otherwise included in net investmentincome in the year of recovery under section 1411(c)(1)(A), the amount ofthe recovery will reduce the taxpayer’s total section 1411(c)(1)(B)properly allocable deductions in the year of recovery (but not belowzero). The preceding sentence applies regardless of whether the amount ofthe recovery is excluded from gross income by reason of section 111. (ii) Recoveries of items allocated between net investment income andexcluded income. In the case of a refund of any item that was deductedunder section 1411(c)(1)(B) in a prior year and the gross amount of thededuction was allocated between items of net investment income andexcluded income pursuant to paragraph (g)(1) of this section, the amountof the reduction in section 1411(c)(1)(B) properly allocable deductions inthe year of receipt under this paragraph (g)(2) is the total amount of therefund multiplied by a fraction. The numerator of the fraction is theamount of the total deduction allocable to net investment income in theprior year to which the refund relates. The denominator of the fraction isthe total amount of the deduction in the prior year to which the refundrelates. (iii) Recoveries with no prior year benefit. For purposes of thisparagraph (g)(2), section 111 applies to reduce the amount of anyreduction required by paragraph (g)(2)(i) of this section to the extentthat such previously deducted amount did not reduce the tax imposed bysection 1411. To the extent a deduction is taken into account in computinga taxpayer’s net operating loss deduction under paragraph (h) of thissection, section 111(c) applies. Except as provided in the precedingsentence, for purposes of this paragraph (g)(2), no reduction of section1411(c)(1)(B) properly allocable deductions is required in a year whensuch recovered item is attributable to an amount deducted in a taxableyear — (A) Preceding the effective date of section 1411, or (B) In which the taxpayer was not subject to section 1411 solely becausethat individual’s (as defined in § 1.1411-2(a)) modified adjusted grossincome (as defined in § 1.1411-2(c)) does not exceed the applicablethreshold in § 1.1411-2(d) or such estate’s or trust’s (as defined in§ 1.1411-3(a)(1)(i)) adjusted gross income does not exceed the amountdescribed in section 1411(a)(2)(B)(ii) and § 1.1411-3(a)(1)(ii)(B)(2). (iv) Examples. The following examples illustrate the provisions of thisparagraph (g)(2). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. Recovery of amount included in income. A, an individual, is a40% limited partner in LP. LP is a passive activity to A. In Year 1, A’sdistributable share of section 1411(c)(1)(A)(ii) income and properlyallocable deductions described in § 1.1411-4(f)(2)(ii) were $50,000 and$37,000, respectively. In Year 2, LP received a refund of a properlyallocable deduction described in § 1.1411-4(f)(2)(ii). A’s distributableshare of the recovered deduction is $2,000. Since the $2,000 recoveryconstitutes gross income described in section 1411(c)(1)(A)(ii) in Year 2,A does not reduce any properly allocable deductions attributable to Year2. Example 2. State income tax refund. In Year 1, D, an individual,allocated $15,000 of taxes out of a total of $75,000 to net investmentincome under paragraph (f)(3)(iii) of this section. D received no taxbenefit from the deduction in Year 1 for chapter 1 purposes due to thealternative minimum tax, but it did reduce D’s section 1411 tax. In Year3, D received a refund of $5,000. For chapter 1 purposes, D excludes the$5,000 refund from gross income in Year 3 by reason of section 111. InYear 3, D allocated $30,000 of state income taxes out of a total of$90,000 to net investment income under paragraph (f)(3)(iii) of thissection. Although the refund is excluded from D’s gross income, D mustnonetheless reduce Year 3’s section 1411(c)(1)(B) properly allocabledeductions by $1,000 ($5,000 x ($15,000/$75,000)). D’s allocation of 331/3% of section 164(a)(3) taxes in Year 3 to net investment income isirrelevant to the calculation of the amount of the reduction required bythis paragraph (g)(2). Example 3. State income tax refund with no prior year benefit. Samefacts as Example 2, except in Year 1, D’s section 1411(c)(1)(B) properlyallocable deductions exceeded D’s section 1411(c)(1)(A) income by $300. Asa result, D was not subject to section 1411 in Year 1. Pursuant toparagraph (g)(2)(iii) of this section, D does not reduce Year 3’s section1411(c)(1)(B) properly allocable deductions for recoveries of amounts tothe extent that such deductions did not reduce the tax imposed by section1411. Therefore, D must reduce Year 3’s section 1411(c)(1)(B) properlyallocable deductions by $700 ($1,000 less $300). (3) Deductions described in section 691(b). For purposes of paragraph(f) of this section, properly allocable deductions include items ofdeduction described in section 691(b), provided that the item otherwisewould have been deductible to the decedent under § 1.1411-4(f). Forexample, an estate may deduct the decedent’s unpaid investment interestexpense in computing its net investment income because section 691(b)specifically allows the deduction under section 163, and §1.1411-4(f)(3)(i) allows those deductions as well. However, an estate ortrust may not deduct a payment of real estate taxes on the decedent’sprincipal residence that were unpaid at death in computing its netinvestment income because, although real estate taxes are deductible undersection 164 and specifically are allowed by section 691(b), the realestate taxes would not have been a properly allocable deduction of thedecedent under § 1.1411-4(f). (4) Amounts described in section 642(h). For purposes of the calculationof net investment income under this section, one or more beneficiariessucceeding to the property of the estate or trust, within the meaning ofsection 642(h), shall — (i) Treat excess capital losses of the estate or trust described insection 642(h)(1) as capital losses of the beneficiary in the calculationof net gain in paragraph (d) and paragraph (f)(4) of this section, asapplicable, in a manner consistent with section 642(h)(1); (ii) Treat excess net operating losses of the estate or trust describedin section 642(h)(1) as net operating losses of the beneficiary in thecalculation of net investment income in paragraphs (f)(2)(iv) and (h) ofthis section in a manner consistent with section 642(h)(1); and (iii) Treat the deductions described in paragraph (f) of this section(other than those taken into account under paragraph (g)(4)(i) or (ii) ofthis section) that exceed the gross investment income described inparagraph (a)(1) of this section (after taking into account anymodifications, adjustments, and special rules for calculating netinvestment income in section 1411 and the regulations thereunder) of aterminating estate or trust as a section 1411(c)(1)(B) deduction of thebeneficiary in a manner consistent with section 642(h)(2). (5) Treatment of self-charged interest income. Gross income frominterest (within the meaning of section 1411(c)(1)(A)(i) and paragraph(a)(1)(i) of this section) that is received by the taxpayer from anonpassive activity of such taxpayer, solely for purposes of section 1411,is treated as derived in the ordinary course of a trade or business notdescribed in § 1.1411-5. The amount of interest income that is treated asderived in the ordinary course of a trade or business not described in §1.1411-5, and thus excluded from the calculation of net investment income,under this paragraph (g)(5) is limited to the amount that would have beenconsidered passive activity gross income under the rules of § 1.469-7 ifthe payor was a passive activity of the taxpayer. For purposes of thisrule, the term nonpassive activity does not include a trade or businessdescribed in § 1.1411-5(a)(2). However, this rule does not apply to theextent the corresponding deduction is taken into account in determiningself-employment income that is subject to tax under section 1401(b). (6) Treatment of certain nonpassive rental activities— (i) Gross incomefrom rents. To the extent that gross rental income described in paragraph(a)(1)(i) of this section is treated as not derived from a passiveactivity by reason of § 1.469-2(f)(6) or as a consequence of a taxpayergrouping a rental activity with a trade or business activity under §1.469-4(d)(1), such gross rental income is deemed to be derived in theordinary course of a trade or business within the meaning of paragraph (b)of this section. (ii) Gain or loss from the disposition of property. To the extent thatgain or loss resulting from the disposition of property is treated asnonpassive gain or loss by reason of § 1.469-2(f)(6) or as a consequenceof a taxpayer grouping a rental activity with a trade or business activityunder § 1.469-4(d)(1), then such gain or loss is deemed to be derived fromproperty used in the ordinary course of a trade or business within themeaning of paragraph (d)(4)(i) of this section. (7) Treatment of certain real estate professionals— (i) SafeHarbor. Inthe case of a real estate professional (as defined in section469(c)(7)(B)) that participates in one or more rental real estateactivities for more than 500 hours during such year, or has participatedin such real estate activities for more than 500 hours in any five taxableyears (whether or not consecutive) during the ten taxable years thatimmediately precede the taxable year, then — (A) Such gross rental income from that rental activity is deemed to bederived in the ordinary course of a trade or business within the meaningof paragraph (b) of this section; and (B) Gain or loss resulting from the disposition of property used in suchrental real estate activity is deemed to be derived from property used inthe ordinary course of a trade or business within the meaning ofparagraph (d)(4)(i) of this section. (ii) Definitions— (A) Participation. For purposes of establishingparticipation under this paragraph (g)(7), any participation in theactivity that would count towards establishing material participationunder section 469 shall be considered. (B) Rental real estate activity. The term rental real estate activityused in this paragraph (g)(7) is a rental activity within the meaning of §1.469-1T(e)(3). An election to treat all rental real estate as a singlerental activity under § 1.469-9(g) also applies for purposes of thisparagraph (g)(7). However, any rental real estate that the taxpayergrouped with a trade or business activity under § 1.469-4(d)(1)(i)(A) or(d)(1)(i)(C) is not a rental real estate activity. (iii) Effect of safe harbor. The inability of a real estate professionalto satisfy the safe harbor in this paragraph (g)(7) does not preclude suchtaxpayer from establishing that such gross rental income and gain or lossfrom the disposition of property, as applicable, is not included in netinvestment income under any other provision of section 1411. (8) Treatment of former passive activities— (i) Section 469(f)(1)(A)losses. Losses allowed in computing taxable income by reason of the rulesgoverning former passive activities in section 469(f)(1)(A) are taken intoaccount in computing net gain under paragraph (d) of this section or asproperly allocable deductions under paragraph (f) of this section, asapplicable, in the same manner as such losses are taken into account incomputing taxable income (as defined in section 63). The precedingsentence applies only to the extent the net income or net gain from theformer passive activity (as defined in section 469(f)(3)) is included innet investment income. (ii) Section 469(f)(1)(C) losses. Losses allowed in computing taxableincome by reason of section 469(f)(1)(C) are taken into account incomputing net gain under paragraph (d) of this section or as properlyallocable deductions under paragraph (f) of this section, as applicable,in the same manner as such losses are taken into account in computingtaxable income (as defined in section 63). (iii) Examples. The following examples illustrate the provisions of thisparagraph (g)(8). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. (i) B, an individual taxpayer, owns a 50% interest in SCorp,an S corporation engaged in the trade or business of retail clothingsales. B also owns a single family rental property, a passive activity. Bmaterially participates in the retail sales activity of SCorp, but B has$10,000 of suspended losses from prior years when the retail salesactivity of SCorp was a passive activity of B. Therefore, the retail salesactivity of SCorp is a former passive activity within the meaning ofsection 469(f)(3). (ii) In Year 1, B reports $205,000 of wages, $7,000 of nonpassive netincome, $500 of interest income (attributable to working capital) fromSCorp’s retail sales activity, and $1,000 of net rental income from thesingle family rental property. B’s Year 1 modified adjusted gross income(as defined in § 1.1411-2(c)) is $205,500; which includes $205,000 ofwages, $500 of interest income, $7,000 of nonpassive income from SCorp,$7,000 of section 469(f)(1)(A) losses, $1,000 of passive income from thesingle family rental property and $1,000 of section 469(f)(1)(C) losses. (iii) For purposes of the calculation of B’s Year 1 net investmentincome, B includes the $500 of interest income and $1,000 of net passiveincome from the single family rental property. The $7,000 of nonpassiveincome from SCorp’s retail sales activity is excluded from net investmentincome because the income is not attributable to a trade or businessdescribed in § 1.1411-5. Therefore, pursuant to the rules of paragraph(g)(8)(i) of this section, the $7,000 of section 469(f)(1)(A) losses arenot taken into account in computing B’s net investment income. However,pursuant to the rules of paragraph (g)(8)(ii) of this section, the $1,000of passive losses allowed by reason of section 469(f)(1)(C), which areallowed as a deduction in Year 1 by reason of B’s $1,000 of passive incomefrom the single family rental property are allowed in computing B’s netinvestment income. As a result, B’s net investment income is $500 ($500 ofinterest income plus $1,000 of passive rental income less $1,000 ofsection 469(f)(1)(C) losses). Although the $500 of interest income isattributable to SCorp and includable in B’s net investment income, suchincome is not taken into account when calculating the amount of section469(f)(1)(A) losses allowed in the current year. Therefore, such income isnot taken into account in computing the amount of section 469(f)(1)(A)losses allowed by reason of paragraph (g)(8)(i) of this section. Pursuantto section 469(b), B carries forward $2,000 of suspended passive lossesattributable to SCorp’s retail sales activity to Year 2. Example 2. Same facts as Example 1. In Year 2, B materially participatesin the retail sales activity of SCorp, and disposes of his entire interestin SCorp for a $9,000 long-term capital gain. Pursuant to §1.469-2T(e)(3), the $9,000 gain is characterized as nonpassive income.Pursuant to section 469(f)(1)(A), the remaining $2,000 of suspendedpassive loss is allowed because the $9,000 gain is treated as nonpassiveincome. Assume that under section 1411(c)(4) and § 1.1411-7, B takes intoaccount only $700 of the $9,000 gain in computing net investment incomefor Year 2. Pursuant to paragraph (g)(8)(i) of this section, B may takeinto account $700 of the $2,000 loss allowed by section 469(f)(1)(A) incomputing net investment income for Year 2. Pursuant to paragraph(g)(8)(i) of this section, B may not deduct the remaining $1,300 passiveloss allowed for chapter 1 in calculating net investment income for Year2. (9) Treatment of section 469(g)(1) losses. Losses allowed in computingtaxable income by reason of section 469(g) are taken into account incomputing net gain under paragraph (d) of this section or as properlyallocable deductions under paragraph (f) of this section, as applicable,in the same manner as such losses are taken into account in computingtaxable income (as defined in section 63). (10) Treatment of section 707(c) guaranteed payments. [Reserved] (11) Treatment of section 736 payments. [Reserved] (12) Income and deductions from certain notional principal contracts.[Reserved] (13) Treatment of income or loss from REMIC residual interests. [Reserved] (h) Net operating loss— (1) General rule. For purposes of paragraph(f)(2)(iv) of this section, the total section 1411 NOL amount of a netoperating loss deduction for a taxable year is calculated by firstdetermining the applicable portion of the taxpayer’s net operating lossfor each loss year under paragraph (h)(2) of this section. Next, theapplicable portion for each loss year is used to determine the section1411 NOL amount for each net operating loss carried from a loss year anddeducted in the taxable year as provided in paragraph (h)(3) of thissection. The section 1411 NOL amounts of each net operating loss carriedfrom a loss year and deducted in the taxable year are then added togetheras provided in paragraph (h)(4) of this section. This sum is the totalsection 1411 NOL amount of the net operating loss deduction for thetaxable year that is allowed as a properly allocable deduction indetermining net investment income for the taxable year. For purposes ofthis paragraph (h), both the amount of a net operating loss for a lossyear and the amount of a net operating loss deduction refer to suchamounts as determined for purposes of chapter 1. (2) Applicable portion of a net operating loss. In any taxable year inwhich a taxpayer incurs a net operating loss, the applicable portion ofsuch loss is the lesser of: (i) The amount of the net operating loss for the loss year that thetaxpayer would incur if only items of gross income that are used todetermine net investment income and only properly allocable deductions aretaken into account in determining the net operating loss in accordancewith section 172(c) and (d); or (ii) The amount of the taxpayer’s net operating loss for the loss year. (3) Section 1411 NOL amount of a net operating loss carried to anddeducted in a taxable year. The section 1411 NOL amount of each netoperating loss that is carried from a loss year that is allowed as adeduction is the total amount of such net operating loss carried from theloss year allowed as a deduction under section 172(a) in the taxable yearmultiplied by a fraction. The numerator of the fraction is the applicableportion of the net operating loss for that loss year, as determined underparagraph (h)(2) of this section. The denominator of the fraction is thetotal amount of the net operating loss for the same loss year. (4) Total section 1411 NOL amount of a net operating loss deduction. Thesection 1411 NOL amounts of each net operating loss carried to anddeducted in the taxable year as determined under paragraph (h)(3) of thissection are added together to determine the total section 1411 NOL amountof the net operating loss deduction for the taxable year that is properlyallocable to net investment income. (5) Examples. The following examples illustrate the provisions of thisparagraph (h). For purposes of these examples, assume the taxpayer is aUnited States citizen, uses a calendar taxable year, and Year 1 and allsubsequent years are taxable years in which section 1411 is in effect: Example 1. (i)(A) In Year 1, A, an unmarried individual, has thefollowing items of income and deduction: $200,000 in wages, $50,000 ingross income from a trade or business of trading in financial instrumentsor commodities (as defined in § 1.1411-5(a)(2)) (trading activity),$10,000 of dividends, $1,000,000 in loss from his sole proprietorship(which is not a trade or business described in § 1.1411-5), $12,000 ofnon-business investment expenses, and $250,000 in trading loss deductions.As a result, for income tax purposes A sustains a section 172(c) netoperating loss of $1,000,000. A makes an election under section 172(b)(3)to waive the carryback period for this net operating loss. (B) For purposes of section 1411, A’s net investment income for Year 1is the excess (if any) of $60,000 ($50,000 trading activity gross incomeplus $10,000 dividend income) over $262,000 ($250,000 trading lossdeductions plus $12,000 nonbusiness expenses). (C) The amount of the net operating loss for Year 1 determined undersection 172 that A would incur if only items of gross income that are usedto determine net investment income and only properly allocable deductionsare taken into account is $200,000. This amount is the excess of $250,000trading loss deductions, over $50,000 trading activity gross income. Undersection 172(d)(4), in determining the net operating loss, the $12,000nonbusiness expenses are allowed only to the extent of the $10,000dividend income. The $200,000 net operating loss determined using onlyproperly allocable deductions and gross income items used in determiningnet investment income is less than A’s actual net operating loss for Year1 of $1,000,000, and accordingly the applicable portion for Year 1 is$200,000. The ratio used to calculate section 1411 NOL amounts of A’s Year1 net operating loss is $200,000 (net operating loss determined using onlyproperly allocable deductions and gross income items used in determiningnet investment income)/$1,000,000 (net operating loss), or 0.2. (ii) For Year 2, A has $250,000 of wages, no gross income from thetrading activity, $300,000 of income from his sole proprietorship, and$10,000 in trading loss deductions. For income tax purposes, A deducts$540,000 of the net operating loss carried over from Year 1. In addition,under § 1.1411-2(c), the $540,000 net operating loss will be allowed as adeduction in computing A’s Year 2 modified adjusted gross income. BecauseA’s modified adjusted gross income is $0, A is not subject to netinvestment income tax. For purposes of A’s net investment incomecalculation, the section 1411 NOL amount of the $540,000 net operatingloss from Year 1 that A deducts in Year 2 is $108,000 ($540,000 multipliedby .2 (the fraction determined based on the applicable portion of the netoperating loss in the loss year)). The amount of the Year 1 net operatingloss carried over to Year 3 is $460,000. For purposes of A’s netinvestment income calculation, this net operating loss carryover amountincludes a section 1411 NOL amount of $92,000 ($460,000 multiplied by0.2). The section 1411 NOL amount may be applied in determining A’s netinvestment income in Year 3. (iii)(A) For Year 3, A has $400,000 of wages, $200,000 in trading gainswhich are gross income from the trading activity, $250,000 of income fromhis sole proprietorship, and $10,000 in trading loss deductions. Forincome tax purposes, A deducts the remaining $460,000 of the net operatingloss from Year 1. In addition, under § 1.1411-2(c), the $460,000 netoperating loss deduction reduces A’s Year 3 modified adjusted gross incometo $380,000. (B) A’s section 1411 NOL amount of the net operating loss deduction forYear 3 is $92,000, which is the $460,000 net operating loss deduction forYear 3 multiplied by 0.2. (C) A’s net investment income for Year 3 before the application ofparagraph (f)(2)(iv) of this section is $190,000 ($200,000 in gross incomefrom the trading activity, minus $10,000 in trading loss deductions).After the application of paragraph (f)(2)(iv) of this section, A’s netinvestment income for Year 3 is $98,000 ($190,000 minus $92,000, the totalsection 1411 NOL amount of the net operating loss deduction). Example 2. (i) The facts for Year 1 are the same as in Example 1. (ii)(A) For Year 2, A has $100,000 in wages, $200,000 in gross incomefrom the trading activity, $15,000 of dividends, $250,000 in losses fromthe sole proprietorship, $10,000 of non-business investment expenses, and$355,000 in trading loss deductions. As a result, for income tax purposesA sustains a section 172(c) net operating loss of $300,000. A makes anelection under section 172(b)(3) to waive the carryback period for theYear 2 net operating loss. (B) For purposes of section 1411, A’s net investment income for Year 2is the excess (if any) of $215,000 ($200,000 trading activity gross incomeplus $15,000 dividend income) over $365,000 ($355,000 trading lossdeductions plus $10,000 nonbusiness expenses). (C) The amount of the net operating loss for Year 2 determined undersection 172 that A would incur if only items of gross income that are usedto determine net investment income and only properly allocable deductionsare taken into account is $150,000. This amount is the excess of $365,000($355,000 trading loss deductions plus $10,000 nonbusiness expenses) over$215,000 ($200,000 trading activity gross income plus $15,000 dividendincome). Under section 172(d)(4), in determining the net operating loss,the $10,000 nonbusiness expenses are allowed in full against the $15,000dividend income. The $150,000 net operating loss determined using onlyproperly allocable deductions and gross income items used in determiningnet investment income is less than A’s actual net operating loss for Year2 of $300,000, and accordingly the applicable portion is $150,000. Theratio used to calculate the section 1411 NOL amount of A’s Year 2 netoperating loss is $150,000 (the applicable portion)/$300,000 (netoperating loss), or 0.5. (iii) For Year 3, A has $250,000 of wages, no gross income from thetrading activity, $300,000 of income from his sole proprietorship, and$10,000 in trading loss deductions. For income tax purposes, A deducts$540,000 of the net operating loss from Year 1. In addition, under §1.1411-2(c), the $540,000 net operating loss will be allowed as adeduction in computing A’s Year 3 modified adjusted gross income. BecauseA’s modified adjusted gross income is $0, A is not subject to netinvestment income tax. The section 1411 NOL amount of the $540,000 netoperating loss from Year 1 that A deducts in Year 3 is $108,000 ($540,000multiplied by 0.2 (the fraction used to calculate the section 1411 NOLamount of the net operating loss)), and this is also the total section1411 NOL amount for Year 3. The amount of the Year 1 net operating losscarried over to Year 4 is $460,000. This net operating loss carryoveramount includes a section 1411 NOL amount of $92,000 ($460,000 multipliedby 0.2) that may be applied in determining net investment income in Year4. None of the Year 2 net operating loss is deducted in Year 3 so that the$300,000 Year 2 net operating loss (including the section 1411 NOL amountof $150,000) is carried to Year 4. (iv)(A) For Year 4, A has $150,000 of wages, $450,000 in trading gainswhich are gross income from the trading activity, $250,000 of income fromhis sole proprietorship, and $10,000 in trading loss deductions. Forincome tax purposes, A deducts the remaining $460,000 of the net operatingloss carryover from Year 1 and the $300,000 net operating loss carryoverfrom Year 2, for a total net operating loss deduction in Year 4 of$760,000. In addition, under § 1.1411-2(c), the $760,000 net operatingloss deduction reduces A’s Year 4 modified adjusted gross income to$80,000. (B) A’s total section 1411 NOL amount of the net operating lossdeduction for Year 4 is $242,000, which is the sum of the $92,000($460,000 net operating loss carryover from Year 1 and deducted in Year 4multiplied by 0.2 (the ratio used to calculate the section 1411 NOL amountof the Year 1 net operating loss)) plus $150,000 ($300,000 net operatingloss carryover from Year 2 and deducted in Year 4 multiplied by 0.5 (theratio used to calculate the section 1411 NOL amount of the Year 2 netoperating loss)). (C) A’s net investment income for Year 4 before the application ofparagraph (f)(2)(iv) of this section is $440,000 ($450,000 in gross incomefrom the trading activity, minus $10,000 in trading loss deductions).After the application of paragraph (f)(2)(iv) of this section, A’s netinvestment income for Year 4 is $198,000 ($440,000 minus $242,000, thetotal section 1411 NOL amount of the Year 4 net operating loss deduction). (i) Effective/applicability date. This section applies to taxable yearsbeginning after December 31, 2013. However, taxpayers may apply thissection to taxable years beginning after December 31, 2012, in accordancewith § 1.1411-1(f).
Last updated by Philip Falco at July 29, 2014 .
Philip M. Falco, CPA is a Colorado licensed Certified Public Accountant with over 18 years of experience. We focus on simple and complex tax compliance. We perform accounting services such as tax return preparation, accounting, payroll, financial statements, and auditing. We put our clients first.
Philip M. Falco, CPA