If you read Part 1 of our blog post series concerning self-rental income, you know that the Net Investment Income (NII) Final Regulations removed self-rental relationships from the inclusion in Bucket 1 of the NII. While the focus of the previous blog post centered with the rental income in Bucket 1, we will now look at the impact of the self-rental relationship impact on Bucket 3 and some additional tax planning considerations.
After the Proposed Regulations were released, many tax professionals suggested converting triple net-lease arrangements to operating leases. An operating lease holds you responsible for more than just collecting money each month. A triple-net lease designates the tenant as solely responsible for all costs and services for the property.
By converting to an operating lease, the belief was that the rental income would not be included in Bucket 1 due to meeting the “derived in a trade or business in which the taxpayer materially participates” language. However, the Final Regulations relieved this concern by exempting activity falling under Reg. §1.469-2(f)(6) and Reg. §1.469-4(d)(1) as illustrated in our previous blog post. By meeting either of those two positions in the Regs, any gain or loss should also be excluded from Bucket 3.
However, there still may be some benefit in converting a triple-net lease into an operating lease even after the change from the Proposed Regs to the Final Regs.
The operating lease may strengthen your position that the rental activity is a trade or business vs. an investment. The disposition of property used in a trade or business is generally considered ordinary under §1231, therefore if the property is disposed of at a loss it might be considered ordinary under §1231 instead of a capital loss (subject to capital loss limits) on investment property. Additionally, if there is a COD event in respect to real property used in trade or business, there may be an opportunity to make an election under §108(c) to reduce the basis of depreciable real property instead of recognizing COD income. This election would not be available if the property was deemed to be an investment property.
If you have further questions regarding the NII tax or your self-rental property, feel free to reach out to me at email@example.com or one of my colleagues.