How do I input income from a K-1 that has income for "Lending Activities" that need to be treated as non-passive

[ORLinvestor]

I have a K-1 that reports income on line 1 from Lending Activities that need to be treated as non-passive pursuant to REG 1.469-2T(F)(4). The investment is actually passive since I do not materially participate, but when I answer the question by saying I do not materially participate, the program puts the income as passive. The only question it asks about treating it as nonpassive is if it is an oil and gas investment, which it is not. How do I make the program report the income as nonpassive without misstating the nature of the investment or my participation?

[tagteam]

You will almost certainly have to do an override (which precludes e-filing your return) on page 2 of Schedule E.

Enter Forms Mode and open page 2 of Schedule E. Override the figure in Column H (in Part II). Delete the figure in that column and then enter the same figure in Column K

[Mike9241]

by doing the override, the line 1 income on the k-1 would transfer to form 8960 which may result in you paying a 3.8% net investment income tax on it. I believe this would be wrong under IRC 1411 - the NIIT code section 

IRC 1411(c)(2)Trades and businesses to which tax applies
A trade or business is described in this paragraph if such trade or business is—
(A)a passive activity (within the meaning of section 469) with respect to the taxpayer, or
(B)a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).

since this is non-passive under the reg you cited. the only workaround that I could come up with to avoid a bunch of overrides in your return(assuming you are subject to NIIT) is to check materially participate. this results in the income ending up in the nonpassive category and is zeroed out on form 8960 so you don't pay the NIIT on this.   the IRS does not know that you answered the question incorrectly. 

[ORLinvestor]

You've raised the issue that has been bothering me too. The activity is totally passive but the income as treated as nonpassive. But there doesn't seem to be any clear answer as to how the recharacterization to nonpassive per Reg 1.469-2T(F)(4) affects the obligation to report the income NIIT under 1411(c)(2).

1411 cites to Section 469, and 469(h)(2) says "Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates." The reg in question never discusses material participation, only the treatment of the income as nonpassive. There seems to be a disconnect between the 2 concepts, even though they are related. So, I am concerned that if I just check the box for material participation, I am not handling it correctly.

I don't know why TurboTax has a question for Oil and Gas investments which have similar recharacterization but didn't include a Q and A for lending activities.

[tagteam]

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@Mike9241 wrote:

by doing the override, the line 1 income on the k-1 would transfer to form 8960 which may result in you paying a 3.8% net investment income tax on it. I believe this would be wrong under IRC 1411 - the NIIT code section 

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An override would have to be effected on Form 8960 as well, assuming the taxpayer is subject to the NIIT.

[tagteam]

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@Mike9241 wrote:

....the IRS does not know that you answered the question incorrectly. 

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It does not always hold true, but they could most likely infer that there was no material participation if the LP box is checked on the K-1 (if that is, in fact, the case).

[Rick19744]

What you don't mention is whether or not there are other separately stated items on your K-1.  This could impact how you enter the K-1 items into TT.

If the only item on your K-1 is on line 1, then I believe you need to indicate in TT that you materially participate.  This assumes the entity which prepared the K-1 meets the qualifications in the temporary regulation you cited; is there a footnote that indicates the entity qualifies?

You should also look at the example in the regulation 1.469-2T(f)(4)(viii).  In particular section (iv) of the example where it specifically states that the individual does not materially participate.

I also don't believe there is any conflict with Section 1411.  While there is no specific mention of the issue you are facing, that is not unusual since regulations get drafted and are in place for decades and yet the tax law evolves and changes.

Based on the above temporary regulation, line 1 is not from a passive activity, so Section 1411 does not apply.  Additionally, the temporary regulation deals with trades or businesses that lend money.  This is not the same as a trade or business of trading in financial instruments or commodities referenced in Section 475.

[ORLinvestor]

Thanks Rick. The income on line 1 is the only box filled it.

I follow all that you say and had read the example you cited. But I have since read Regs § 1.1411-4 and 1.1411-5. They lead me to the conclusion that I owe the NIIT pursuant to section 1411 because the activity is passive even though the income is recharacterized as nonpassive by 1.469-2T(f)(4). The way I read the situation is that 1.1411-5(b)(2)(i) specifically  identifies several recharacterizations that cause the trade or business to "not constitute a passive activity". Since (f)(4) is excluded from that list, I have to assume that is intentional and the reg does not intend the recharacterization of the income to result in a similar recharacterization of the activity.

If I check the box for materially participate, the program will exclude the income from the NIIT calculation on form 8960. That would likely raise a red flag to the IRS. From fiddling around, I see that if I answer yes to the question about the income being from oil and gas, the program puts the income in the nonpassive column but still counts it as NIIT on 8960. This seems to be the proper way to deal with it and comply with both sections 469 and 1411.

[Rick19744]

I agree with you that since (f)(4) is excluded in 1.1411-5, it is subject to the NIT.

I think your work around gets you the correct result.

TT software is designed for the masses and quirky situations such as yours may never get addressed.  Most likely not in their top 50 list. 

Commendable in your diligence in following up on this issue.