Passive activity loss rules are complicated and require careful attention. In general, their purpose is to limit or prevent taxpayers from deducting passive losses, unless the taxpayer has offsetting passive income.
Previously, passive income had been a positive: a taxpayer without passive losses would recognize the passive income regardless; a taxpayer with passive losses could offset the passive losses with passive income.
But starting in 2013, the recognition of passive income has a down side: the Medicare Tax on Net Investment Income (MTNII) [IRS §1411]. “Excess” passive income, that is passive income left after offsetting passive losses, may be subject to an additional 3.8% excise tax.
Taxpayers must take time to review their passive income, and investigate the options available for reducing or eliminating “excess” passive income. If a taxpayer can change his involvement with the activity (see the material participation rules in Regs. §§1.469-5T(a)(1)-(7)), he may be able to reduce his passive income and his exposure to the MTNII.
Fiduciaries will be hard-pressed to avoid the MTNII, since it is generally difficult for a fiduciary to demonstrate material participation. Combined with the trust’s low threshold, any trust which does not distribute out its net investment income will likely be subject to the excise tax.