NII Tax

[rdo cpa]

An LLC with 2 members rent a building to a business that is owned by the same 2 people that own the partnership. Both owners work full time in the business (a true trade of business).

Is the rental income passed through on the K-1s subject to the NII Tax?

[Bees Knees]

It has to be a Section 162 trade or business to avoid the NII Tax. Renting a building is not in itself a trade or business, thus, it is subject to the tax.

The reason you keep the real estate outside of the business entity by renting it to the business entity (as opposed to having the business entity own the real estate) is so that you can convert some of the business profits into rental income. Business profits in the case of a partnership or sole prop are generally subject to SE tax. Business profits in the case of a corporation usually come out in the form of wages subject to FICA. Rental income is not subject to SE tax or FICA. That strategy was fine under the old rules, but it is now a negative for those subject to the NII Tax. If you want to avoid the NII Tax, the building should be owned by the entity conducting the Section 162 trade or business.

Having said that, if the Section 162 trade or business is a corporation, there are other more important reasons to keep the real estate outside of the business. So I am not suggesting you tell your clients to put the building inside their business.

[rdo cpa]

To hopefully clarify my original question: the same 2 individuals own both the LLC and the business entity. The LLC rents the building to the business entity. Both owners also work full time in the business entity.

Is this considered a self-rental? It is my understanding of the recharacterization rules for regular income tax purposes that rental income from a self-rental is non-passive but a loss from a self-rental is still passive.

If so, is it a non-passive investment that is not subject to the passive activity rules because of recharacterization of the rental income. If this is true, does it follow that it is not subject to the NIIT?

[Bees Knees]

I don't think so, because the regulations for the NII Tax say that a rental real estate activity has to be a Section 162 trade or business to avoid the NII Tax.

[Maribeth]

The final regs released at the end of November 2013 clarify the treatment of self-charged rental income. The income derived from the rental is considered to be income derived from a trade or business and is NOT subject to the NII. Gain or loss on the sale of the property is also NOT subject to NII.

[JON]

Self rental

was a surprise exclusion in the final regs. I think it is exempt from your description. You do not make any election at the partnership/corp level + NII is at the 1040 level corect??!!