IRS Gives High-Income Taxpayers a Break on Tax Loss Treatment

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The IRS has finally given high-income taxpayers a break with the release of the final regulations governing the new 3.8% tax on net investment income.

These final rules mark a dramatic shift from the IRS’s previous position, which would have severely limited the value of losses produced by the sale of your clients’ property for purposes of the investment income tax. By adding flexibility to the rules governing the treatment of losses derived from investment income-producing property, the IRS’s unanticipated amendments allow your clients to take full advantage of the value of their capital losses, finally easing the sting of the investment income tax.

Applying the Investment Income Tax to Property Sales

In general, for clients whose income exceeds the annual threshold amounts, the investment income tax applies to three types of income: (1) income from dividends, interest, annuities, royalties, rents, substitute interest payments and substitute dividend payments; (2) gross income derived from a trade or business that is either treated as a passive activity or involves trading in financial instruments or commodities; and (3) gain derived from the sale of property. Because the tax is added to any otherwise applicable taxes, it will substantially increase the tax burden felt by many high-income clients.

However, exceptions do exist—gain derived from the sale of property can escape the 3.8% tax if the property was held in a trade or business that is not a passive activity and that does not involve trading in financial instruments or commodities. Gain on the sale of a principal residence can also be excluded if it could otherwise be excluded under generally applicable rules, meaning that the property was used as a residence for two of the five years prior to sale and the gain does not exceed the $250,000/$500,000 threshold level.

Proposed vs. Final Regulations: Loss Treatment

The final regulations change the way that losses can be used to offset any gains generated by property sales that would otherwise be subject to the 3.8% tax. The proposed regulations allowed clients to use losses generated by the sale of property only to offset any gains generated by the sale of property, meaning that, for example, those losses could not be used to offset income from interest or passive activity-type income.

Because the proposed regulations also prohibited a taxpayer from using losses to reduce gains to below zero, in many cases those losses would lose their value if the taxpayer did not also have substantial gains from the sale of property during that tax year.

Under the final regulations, however, the IRS—while maintaining the prohibition against using losses to reduce gains to below zero—allows your clients to use losses generated from property sales to offset gains attributable to other types of investment income (such as interest income) as long as the loss would be allowable in computing taxable income under generally applicable tax rules.

Therefore, for example, even if your client has no gains from property sales during the tax year, he could use $3,000 worth of losses generated from property sales (as is allowable under IRC Section 1211) to offset gains that are derived from some other form of taxable investment income. The final regulations permit this type of offset so long as the generally applicable rules permit the loss to be used in calculating taxable income.

Conclusion

While the new investment income tax is bound to increase the tax liability for many clients, the treatment of losses under the newly finalized regulations presents a new planning opportunity for clients who anticipate they will recognize both gain and loss over the coming years. With proper planning, your clients can ease the sting of the investment income tax for 2013 and beyond.

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