Does the Sale of Farmland Trigger Net Investment Income Tax?

Overview

One of the new taxes created under Obamacare is a 3.8 percent tax on passive sources of income of certain individuals.  It’s called the “net investment income tax” and it took effect in January of 2013.  Its purpose was to raise about half of the revenue needed for Obamacare.  It’s a complex tax that can surprise an unsuspecting taxpayer – particularly one that has a one-time increase in investment income (such as stock).  But it can also apply to other sources of “passive” income, such as income that is triggered upon the sale of farmland.

But are farmland sales always subject to the additional 3.8 percent NIIT?  Are there situations were the sale won’t be subject to the NIIT?  These questions are the topic of today’s post.

Background

The NIIT is 3.8% of the lesser of (1) net investment income (NII); or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). I.R.C. §1411.  The threshold amount is not indexed for inflation.  For this purpose, MAGI is defined in Treas. Reg. §1.1411-2(c)(2).  For an estate or trust, the NIIT is 3.8% of the lesser of (1) undistributed NII; or (2) the excess of AGI (as defined in I.R.C. §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($12,750 for 2019).  I.R.C. §1411(a)(2).   

What is NII? For purposes of the NIIT, net investment income (NII) is gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NII tax doesn't apply. I.R.C. §1411(c)(1)(A)(i).  If the taxpayer either owns or is engaged in a trade or business directly or indirectly through a disregarded entity, the determination of character of income for NIIT purposes is made at the individual level.  Treas. Reg. §1.1411-4(b)(1).  If the income, gain or loss traces to an investment of working capital, it is subject to the NIIT.  I.R.C. §1411(c)(3).  Also, the NIIT applies to business income if the trade or business at issue is a passive activity.  I.R.C. §1411(c)(2)(A). But, if income is subject to self-employment tax, it’s not NII subject to the NIIT.  I.R.C. §1411(c)(6). 

Sale of Farmland and the NIIT

Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of I.R.C. §469. 

If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales – the I.R.C. §469(f)(3) approach and the I.R.C. §469 approach

I.R.C. §469(h)(3) approach.  I.R.C. §469(h)(3) provides that “a taxpayer shall be treated as materially participating in any farming activity for a taxable year if paragraph (4) or (5) of I.R.C. §2032A(b) would cause the requirements of I.R.C. §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died during the taxable year.” The requirements of I.R.C. §2032A(b)(1)(C)(ii) are met if the decedent or a member of the decedent’s family materially participated in the farming activity five or more years during the eight years preceding the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the decedent was retired or disabled.  I.R.C. §2032A(b)(4). If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively manages the farming activity when the spouse is not retired or disabled.   I.R.C. §2032A(b)(5).

To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer is continually receiving social security benefits or is disabled; and materially participated in the farming activity for at least five of the last eight years immediately preceding the earlier of death, disability, or retirement (defined as receipt of social security benefits).

The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive social security benefits, the surviving spouse must only actively participate in the farming operation to meet the material participation test. 

“Normal” I.R.C. §469 approach. A counter argument is that I.R.C. §469(h)(3) concerns the recharacterization of a “farming activity,” but not the recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity, §469(h)(3) does not apply and the normal material participation tests under §469 apply. 

What are the material participation tests of I.R.C. §469?  As set forth in Treas. Reg. §1.469-5T, they are as follows:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity  of any other individual (including individuals  who are not owners of interests in the activity) for such year;

(4) The  activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The above tests don’t apply to a limited partner in a limited partnership, and only one of the tests is likely to have any potential application in the context of a retired farmer to determine whether the taxpayer materially participated in the farming activity – the test of material participation for any five years during the ten years preceding the sale of the farmland. 

Clearly, the “normal” approach would cause more  transactions to be subject to NIIT.  It’s also the approach that the IRS uses, and it is likely the correct approach.

Sale of land held in trust.  When farmland that has been held in trust is sold, the IRS position is that only the trustee of the trust can satisfy the material participation tests of §469.   This is an important point because of the significant amount of farmland that is held in trust, particularly after the death of the first spouse, and for other estate and business planning reasons.  However, the IRS position has been rejected by the one federal district court that has ruled on the issue.  Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003).  The IRS did not appeal the court’s opinion, but continued to assert in in litigation in other areas of the country.  In a case from Michigan in 2014, the U.S. Tax Court in a full tax court opinion, rejected the IRS’s position.  Frank Aragona Trust v. Comm’r, 142 T.C. 165 (2014).    The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of non-trustee employees would count toward the material participation test.  The court’s opinion makes it less likely that the NIIT will apply upon trust sales of farmland where an actual farming business is being conducted.

Conclusion

Obamacare brought with it numerous additional taxes.  One of those, the NIIT, applies to passive income of taxpayer’s with income above a certain threshold.  The NIIT can easily be triggered upon sale of particular assets that have been held for investment or other purposes, including farmland.  Some planning may be required to avoid its impact.