IRS AUDIT WAR PART II DONT BECOME A

IRS AUDIT WAR PART II DON’T BECOME A CASUALTY AND YOU CANNOT USE THE EXCUSE ALL THE DATA WAS ON YOUR HARD DRIVE, WHICH JUST CRASHED AUGUST 7, 2014 South Bay Association of Realtors David L. Rice, J. D. LL. M Elizabeth Nelson, J. D. CA Certified Tax Specialist & Certified Elder Law Specialist Masters of Law in Taxation Former Chair, ABA Individual and Family Income Tax Committee Vice Chair, ABA Individual and Family Income Tax Committee Former Chair of State Bar Committee of Taxation Specialist Former Chair of State Bar Committee on Tax Procedure and Litigation

How Do I qualify as a Real Estate Professional? 1. Under IRC § 469, real estate rental income is per se passive except for Real Estate Professionals materially participating in the rental activity. 2. There is an exception for up to a $25, 000 loss if the taxpayer is actively involved. 3. Generally you can only group rental activities with a trade or business providing that the activity of one is insubstantial in relationship to the other. A. Attorney D is a sole practitioner in Torrance and also owns real estate in Torrance that he rents out to third parties. Given the facts and circumstances, the law practice and the residential real estate do not constitute an appropriate economic unit. Therefore D may not treat the law practice and the residential real estate as a single activity. B. Suppose the attorney had an office building and rented out an office. Could he group the activities? If the rental activity income is insubstantial in relationship to the law firms fees, then it could be grouped.

How Do I Become a Real Estate Professional? Beginning in 1994, a real estate professional may treat rental real estate activities as non-passive if the taxpayer materially participates in the rental activities. [2] The material participation requirement applies separately to each rental activity (unless the taxpayer made a timely election to group all his rentals as a single activity). These rules apply to individual taxpayers and closely held C Corporations. See checksheet and interview questions at end of chapter. Issues To qualify as a real estate professional, the taxpayer must spend: 1. More than 50 percent of his/her time in real estate activities; and 2. More than 750 hours in real estate activities. A real estate professional must materially participate in each rental activity for the loss to be deductible. [3] Exception: A real estate professional may file a written election to group all rental real estate activities as one activity. As a practical matter, most elections were filed in 1995. However, the taxpayer may file the election in any year, and it will bind future years from that point.

How Do I Become A Real Estate Professional? Real Estate Professional To be a real estate professional, an individual must spend the majority of his or her time in real property businesses: Development or redevelopment Construction or reconstruction Acquisition or conversion Rental Management or operation Leasing Brokerage

How Do I become a Real Estate Professional? The taxpayer must meet each of the following two time requirements: More than 50% of his/her time working in real property businesses; and More than 750 hours of service during the year. One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5% owner. Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental activity.

How Do I Become a Real Estate Professional? Material Participation for Real Estate Pros A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. The material participation test then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on Form 8582.

How Do I Qualify as a Real Estate Professional? A taxpayer, who does most of the work in a rental, meets Test 2 for material participation in Reg. § 1. 469 -5 T(a)(2). However, if there is onsite management, it may be difficult for the taxpayer to materially participate because: Rental activities, by nature, normally do not require significant day-to -day involvement, i. e. they are not time intensive. For many taxpayers using any kind of outside management, the only material participation test available is the 500 hour test. In many situations, the other tests will not apply. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.

How Do I Become A Real Estate Professional? Election to Group Rental Real Estate A real estate professional may make an election to group all rental real estate activities as one single activity. In order to make a valid election, Treasury Regulation § 1. 469 -9(g) requires a taxpayer to file a written statement and attach it to an original return. This election cannot be made on an amended return or during an audit!

IRS AUDIT TECHNIQUES Issue Identification Check to see if all Schedule E rental real estate losses have been deducted as non-passive, possibly not considering the fact that the taxpayer must materially participate in each rental activity. Look at the taxpayer’s occupation next to the signature block and Schedule E line 43. To be a real estate professional, the taxpayer must spend the majority of time in real property businesses and/or rental real estate. Review the Schedule E activities, Schedule K-1 s for Form 1065 and Form 1120 S returns, and W-2 s for other indications regarding the nature of the taxpayer’s activities.

IRS AUDIT TECHNIQUES Determine whether the taxpayer materially participates in one or more of the specific real estate trades or businesses listed above. Determine who is the real estate professional, husband or wife. Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. § 1. 469 -5 T(f)(4) to provide proof of services performed and the hours attributable to those services. Scrutinize other activities the taxpayer is engaged in to determine whether time claimed makes sense. Qualification as a real estate professional is a determination, not an election. A taxpayer may attempt to manipulate the passive activity rules by inappropriately claiming to be a real estate professional, or conversely, by not claiming to be one (for instance, if certain activities are generating net income).

IRS AUDIT TECHNIQUES Review W-2 s and other non-passive activities. Does it seem likely that the taxpayer could spend 500 hours on the activity in light of other employment obligations? Ask questions on taxpayer activity time early in the examination. Establish time the taxpayer spends on all activities during the initial interview if possible. See exhibit with log at the end of the chapter. Determine the location of each activity. If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?

ACTIVITY LOG Activity Log Business/Property: _________ Year: ______ Complete the following by day: ________________________________________________________________ ________________________________________________________________ ________________________________ Under penalties of perjury, I declare that I have examined the information contained on this worksheet, including attached worksheets and statements, and to the best of my knowledge and belief, it is true, correct and complete. _________________ Signatures (both spouses, if married) Date Reg. § 1. 469 -5 T(f)(4) provides that reasonable means for proving hours may include a statement of services performed AND approximate hours based on appointment books, calendars, etc. To meet his burden of proof under IRC 7491, the taxpayer must comply with the recordkeeping requirements of the regulations.

IRS EXAMINTATION TECHNIQUES Question the taxpayer in the initial interview whether an election was made, grouping rental real estate interests as a single activity. Request a copy of the return with the election. Request the original Form 1040, U. S. Individual Income Tax Return, from the IRS Center if doubts exist as to the documents furnished. Review prior and subsequent year’s returns for consistency. Closely scrutinize any passive income on Form 8582 line 1 a. If the taxpayer is a real estate professional and did most of the work on the rental, gain on disposition does not belong on Form 8582.

IRS AUDIT TECHNIQUES Passive loss limitations for rental real estate generally apply to: Leased residential property Leased vacation homes if average rental period is more than 7 days. Leased condos if average rental period is greater than 7 days. Leased commercial buildings Leased land Mini-warehouses Self-storage units ISSUE: Does the taxpayer actively participate and does he qualify for the $25, 000 special allowance under IRC § 469(i)?

IRS AUDIT TECHNIQUES ____ Have rental real estate losses been limited to $25, 000 (or up to passive income from another passive activity)? If not, limit losses to $25, 000, and continue on to verify active participation. If yes, continue on to verify active participation. ____ Is MAGI more than $150, 000? MAGI is simply AGI computed without rental losses and any other passive losses and some minor modifiers. If AGI is more than $150, 000, MAGI is almost always more than $150, 000. If AGI plus the rental losses is more than $150, 000, MAGI is more than $150, 000. ____Isthetaxpayeralimitedpartner(andnotalsoageneralpartner)? See IRC § 469(i)(6)(B). Note: Since many investors in low income housing are limited partners, losses will not qualify for the active participation standard and should be on line 3 b. Therefore, no $25, 000 offset is available. While LIHC are excepted from the active participation requirement, no such exception exists for LIH losses. _____ Does the taxpayer own less than 5 percent? See Schedule K-1. _____ Are losses from an activity other than real estate? Equipment, computers, boats, vehicles, etc. Leases of personal property are generally passive regardless of the level of participation See IRC § 469(c)(2)&(4). If answers to any of the last 3 questions are answered YES, Taxpayer does not qualify for $25, 000 offset.

IRS AUDIT TECHNIQUES _____ Verify that one spouse alone meets BOTH of the following tests. FIRST TEST: Are more than half of personal services in all businesses (T/B) for the year performed in real property T/B and rental real estate? --Real property T/B = real property development, construction, acquisition, conversion, rental operation, management, leasing or brokerage. Time spent as an employee in real property activities counts only if the taxpayer is more than a 5 percent owner. SECOND TEST: Does taxpayer spend more than 750 hours in real property businesses and rentals in which he materially participates? _____ If answer is NO to either of above two tests, IRC § 469(c)(7) does not apply, and losses are generally limited to $25, 000. _____ If answer is YES to both tests, apply material participation tests to each rental real estate activity to determine whether each activity is passive or non-passive. While not seen often, the taxpayer may have made a onetime election to group all rentals as a single activity. Thus material participation is determined based on the grouped rentals. See IRC§ 469(c)(7)(A)and Reg. § 1. 469 -9(g).

IRS AUDIT TECHNIQUESS Per IRC § 469(c)(7), the following rental real estate activities have been determined to be non-passive and current (but not carryover) losses are fully deductible: _______ Current losses are entered on Schedule E, but not on FORM 8582. Taxpayer is a real estate professional, but did not materially participate in the following real estate activities: _______ He does, however, actively participate, making management decisions. Losses are entered on FORM 8582 line 1 a. Taxpayer does not actively participate in the following rental real estate activities: _______. Limited partners and Taxpayers who own less than 10 percent cannot rise to the active participation standard. Losses are entered on FORM 8582, line 3 b (2 b for years before 2002).

IRS AUDIT TECHNIQUES Real Estate Professional: Interview Half Personal Services Test _____ Describe the work you perform as a real estate professional. Check occupations by signatures and W-2 s. _____ Who is the real estate professional, you or your spouse? _____ Does the spouse claiming to be the real estate professional work full-time or part-time? If the taxpayer has a full-time job working 2080 hours a year in a non-real property business, he must work 2081 on his real property businesses to meet half-personal services test! _____What percentage of each real property business(es) do you own? Unless taxpayer owns 5 percent or more, time is not counted. See IRC § 469(c)(7)(D)(ii). If, for example, the taxpayer works full-time for a construction company, but does not own any of the company, he is not a real estate professional.

IRS AUDIT TEHCNIQUES 750 HOUR TEST Time does not count for purposes of the 750 hour test and the half personal services test – unless the taxpayer materially participates in the activity. One spouse ALONE must meet the 750 hour test. _____ Who performs the services, husband or wife? Hours by husband? Hours by wife? _____ Approximately how many hours did you spend working on your rentals in the year under exam? Ask the taxpayer for supporting documentation (appointmentbooks, diaries, calendars, logs, etc. ) Youmaywanttogive taxpayer a log to be completed for each rental – and for each year under exam. Material participation is a year by year determination. Rentals are generally not time intensive. _____ If non-working spouse claims to be the real estate professional, ask what other commitments he/she may have. Is the spouse a student? Is the spouse providing full-time care to young children?

IRS AUDIT TECHNIQUES MATERIAL PARTICIPATION IN THE RENTALS _____ Who monitors the rentals? Who collects the rent? Who does the repairs? _____ Do you have a real estate agent or manager or employee responsible for any of the rentals? Ask for each rental property. Check Schedule E properties for large commissions or management fees. Also check for large labor expense – possibly a hired contractor spent more time than taxpayer. If there is paid management, it is a strong indicator taxpayer did not materially participate. _____ Is anyone besides you involving with managing or overseeing any the properties? Does a relative or friend manage/monitor the property for free? _____ Does a tenant receives free/reduced rent for managing the rentals – or for caring for the properties?

2010 Health Care Act H. R. 4872 P. L. 111 -152 The 2010 Health Care Act increased the Medicare portion of the self- employment tax by. 9% (to 3. 8%) (the “Additional Medicare Tax”) on earnings in excess of $250, 000 in the case of married taxpayers filing a joint return, $125, 000 for married taxpayers filing a separate return, and more than $200, 000 for all other taxpayers, effective for tax years beginning after December 31, 2012. The 2010 Health Care Act subjects investment income (rather than income derived from labor, as in the case of the SE tax), for the first time in the history of Social Security, to a similar tax (the “NII Tax”). Effective January 1, 2013, new section 1411(a)(1) imposes a separate 3. 8% tax on the lesser of (a) “net investment income” or (b) the excess of modified adjusted gross income (“MAGI”) over $250, 000 in the case of married taxpayers filing a joint return, $125, 000 for married taxpayers filing a separate return, and over $200, 000 for all other taxpayers.

Definition of Net Investment Income • Section 1411(c)(1) provides that NII means the excess (if any) of • the sum of – Category 1: gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply; – Category 2: other gross income derived from a trade or business to which the tax applies: • a passive activity, or • trading in financial instruments or commodities; – Category 3: net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity or trading business; over, • the deductions allowed by subtitle A which are properly allocable to such gross income or net gain.

Trade or Business Non-Passive vs. Passive • Active trade or business income. NII does not include income derived from a trade or business that is neither a passive activity with respect to the taxpayer nor involves trading in financial instruments and commodities (that is, a trade or business not described in section 1411(c)(2)). • Section 1411's statutory language and legislative history do not provide a definition of trade or business. The most established definition of trade or business is found under section 162(a), which permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business.

Trade or Business 24 • Under the long standing principles enunciated in Whipple v. Commissioner, 373 U. S. 193 (1963), 83 S Ct. 1168, 63 -1 USTC p 9466 (1963) the activities of an investor are distinguishable from a taxpayer in a trade or business. • For tax purposes, ‘‘trade or business’’ has a variety of uses, but it is not defined anywhere in the Internal Revenue Code or in any comprehensive regulation. Commissioner v. Groetzinger, 480 U. S. 23(1987), is commonly cited to define a trade or business as existing when (1) the taxpayer is engaged in an activity with the primary purpose of income or profit, and (2) that activity is conducted with continuity and regularity. • Income from the trade or business of trading in commodities is taxable as NII, regardless of whether the taxpayer materially participates.

Material Participation by a Partner or S Corporation Shareholder • An Individual partner or S corporation shareholder participates in an entity level activity only if he or she is involved in the operations of the activity on a “regular, continuous and substantial basis. ” Any participation in the entity level activity by a partner or S corporation shareholder in any capacity is treated as participation. However, there are three exceptions to this general rule: – Work Not Customarily Performed by an Owner – -Participation as an Investor – Limited Partners -

Material Participation by Limited Partner • Generally treated as passive unless the Limited Partner meets one of the following tests: • 500+ hour test • The limited partner participates in the activity for any out of the 10 immediately preceding tax years. • The activity is a personal service activity in which the limited partner materially participated for any 3 preceding tax years.

Fresh Start Election to Redetermine Passive Activity Groupings • Final regulations allow for regrouping for NII purposes beginning first taxable year after December 31, 2013, in which taxpayer is subject to NII Tax. – Only allowed to regroup once for NII Tax purposes – Only applies to individuals, estates and trusts (not to passthrough entities) – Taxpayers whose tax year begins in 2013 also allowed to regroup – Regrouping allowed on amended return only if taxpayer was not subject to NII Tax on original return, but due to change in original return, is now subject to NII Tax – If taxpayer regroups on original return and it is then determined taxpayer is not subject to NII Tax, regrouping election is void unless a valid regrouping is done • Section 9100 relief is not available for missed regrouping.

Grouping of Rental and Trade or Business Activities • Rental and trade or business activities generally cannot be grouped unless they are an “appropriate economic unit” and – Rental activity is “insubstantial” in relation to trade or business activity (rental activity ceases to be a rental activity for section 469 purposes) – Trade or business activity is “insubstantial” in relation to rental activity (trade or business activity is subsumed into the rental activity for section 469 purposes) or – Identical ownership (permits aggregation only of portion of rental to the trade or business activity) • Real property and personal property rental activity cannot be grouped except rental of – Personal property provided in connection with real property – Real property provided in connection with personal property

NII and Rental Real Estate Activities • For trade or business exception to NII Tax to apply, income must be derived from a trade or business – Only if the rental income is nonpassive under section 469 with respect to the taxpayer does the determination of whether a section 162 trade or business exists becomes relevant. Generally, rental real estate activities qualify as trade or business activities. • Query: Does the taxpayer file Form 1099 s to service providers? – Information reporting required for trade or business activities, but not section 212 rentals – Stiff penalties for noncompliance under section 6041 • Rentals that may not be a trade or business – Rentals of non-depreciable property under Reg. § 1. 469 -2 T(f)(3) – Triple net leases – Rentals that do not require regular, continuous, and substantial involvement by the owner (see Reg. § 1. 212 -1(h)

Non-Passive Rental Income – The Real Estate Professional The Final Regulations provide that rental income from real property is not NII if the taxpayer is a “real estate professional” and all of the following apply: – More than one-half of personal services performed in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates – Such taxpayer performs more than 750 hours of services in real property trades or businesses in which taxpayer materially participates – Qualifying services do not include services performed as an employee, unless the employee is a “ 5 -percent owner” of the employer (see section 469(c)(7)(D)(ii))

Non-Passive Rental Income – The Real Estate Professional Being a real estate professional ‘turns off’ section 469(c)(2) and allows the taxpayer to test material participation in real estate activities, provided: – The rental activity qualifies as a trade of business for purposes of section 162(a), and – The taxpayer materially participates with respect to the real estate rental activity The election to treat all real estate as a single activity under Reg. § 4699(g) also applies and may help the taxpayer meet the material participation tests.

Non-Passive Rental Income – The Real Estate Professional • Real estate professional safe harbor under the Final Regulations: • The safe harbor test provides that if a real estate professional within the meaning of section 469(c)(7) participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business. • Alternatively, the taxpayer may satisfy this test if the taxpayer was involved in rental real estate activities for more than 500 hours per year in five of the last ten taxable years (including years before the effective date of section 1411). • Finally, the failure of a taxpayer to satisfy the 500 hour safe harbor test will not preclude the taxpayer from establishing that gross rental income and gain or loss from the disposition of property, as applicable, is not included in net investment income.

Rental Real Estate Activities and the Conduct of a Trade or Business • Example 1 of Reg. § 1. 1411 -5(b)(2) provides as follows: – A, an unmarried individual, rents a commercial building to B for $50, 000 in Year 1. A is not involved in the activity of the commercial building on a regular and continuous basis, therefore, A’s rental activity does not involve the conduct of a section 162 trade or business, and under section 469(c)(2), A’s rental activity is a passive activity. Because paragraph (b)(1)(i) of this section is not satisfied, A’s rental income of $50, 000 is not derived from a trade or business described in paragraph (b)(1) of this section. However, A’s rental income of $50, 000 still constitutes gross income from rents within the meaning of § 1. 1411 - 4(a)(1)(i) because rents are included in the determination of net investment income under § 1. 1411 - 4(a)(1)(i) whether or not derived from a trade or business described in paragraph (b)(1) of this section.

NII and Rental Real Estate Activities Real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. Essentially three requirements must be met for an individual to treat rental income as not subject to NII Tax: – Rental income must be derived from a rental trade or business. – The individual must be a real estate professional under section 469(c)(7). – The individual must materially participate in rental activity. Aggregation – For purposes of real estate professional exception, all rental real estate activities are treated as separate activities. – The taxpayer may elect to aggregate and treat all rental real estate activities as a single activity. – The election is binding for taxable year made and all future years. – The election may be revoked if there is a material change in facts.

Recharacterization of Passive Net Income Real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. Essentially three requirements must be met for an individual to treat rental income as not subject to NII Tax: – Rental income must be derived from a rental trade or business. – The individual must be a real estate professional under section 469(c)(7). – The individual must materially participate in rental activity. Aggregation – For purposes of real estate professional exception, all rental real estate activities are treated as separate activities. – The taxpayer may elect to aggregate and treat all rental real estate activities as a single activity. – The election is binding for taxable year made and all future years. – The election may be revoked if there is a material change in facts.

Self-Charged Interest • In the case of interest income from a loan to a passthrough entity in which the taxpayer materially participates, the amount of interest income equal to the taxpayer’s allocable share of the nonpassive deduction is treated as derived in the ordinary course of a nonpassive trade or business, and so is excluded from NII • This rule cross-references the self-charged interest rules of Reg. § 1. 469 -7 • This special rule does not apply when the interest expense deduction is taken into account in determining self-employment income – i. e. , a nonpassive activity owned via a general partnership interest or LLC interest in which the distributive share is included in the individual’s self-employment calculation

Self Charged Rentals • Passive income recharacterization for Self-Charged Rentals The Final Regulations provide that to the extent gross rental income is treated as not derived from a passive activity under the special rule of Reg. § 1. 469 -2(f)(6), or as a consequence of a taxpayer grouping of a rental activity with a trade or business activity under Reg. § 1. 469 -4(d)(1), then such gross rental income is deemed to be derived in the ordinary course of a trade or business. Reg. § 1. 1411 -(g)(6)(i) A similar rule applies to gain or loss upon the disposition of the property, excluding such gain or loss from the definition of net income if the taxpayer materially participates in the trade or business. Reg. § 1. 1411 -(g)(6)(ii)

NII Tax on Estates and Trusts For estates and trusts, the new tax on NII only applies to undistributed NII of the estate or trust that is subject to the “highest tax bracket in section 1(e)” (income in excess of $11, 950 for tax year 2013, $12, 150 for tax year 2014). • The Final Regulations provide that NII of an estate or trust is its NII (as determined under Reg. § 1. 1411 -4) reduced by the share of NII included in the deductions of the estate or trust under section 651 or section 661, and the share of NII allocated to the section 642(c) deduction of the estate or trust in accordance with Reg. § 1. 642(c)-2(b) and the allocation and ordering rules under Reg. § 1. 662(b)-2. • The Final Regulations adopt the class system of income categorization, generally embodied in sections 651 through 663 and the regulations, to arrive at the trust's NII reduction in the case of distributions that are comprised of both NII and net excluded income items. • Items of income characterized as NII and currently distributed to beneficiaries as DNI retain the character of NII for purposes of determining the NII Tax liability of the beneficiaries. •

Material Participation by an Estate or Trust • To determine whether a trust or estate meets active participation requirements in section 469, there is uncertainty as to participation of which parties is considered. – Look to trustees, employees, third-party agents – Mattie K. Carter Trust v. United States, 256 F. Supp. 2 d 536 (N. D. Tex. 4/11/03) – Look only to trustees who are considered fiduciaries – Tech. Adv. Memo. 2007 - 33 -023 (8/17/07), Priv. Ltr. Rul. 2010 -29 -014 (4/7/10) and Tech. Adv. Memo. 2013 -17 -010 (4/26/13); count only participation in role as fiduciary – Look to employees and fiduciaries – Aragona v. Comm’r, 142 T. C. No. 9 (3/27/2014) If the grantor actively participates in the activity, consider whether the trust should be a grantor trust. Consider whether the beneficiary or other person who actively participates in activity should be made a trustee of trust.

NII Tax on the Net Gain from Dispositions of Property or Interests in Partnerships and LLCs. • The new NII Tax applies to “net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business, ” unless that trade or business is either a passive activity with respect to the taxpayer or involves trading in financial instruments or commodities. • “Property held in a trade or business” is specifically excluded, as long as such trade or business does not fall within the passive activity/trading in financial instruments and commodities categories. • Gain from the disposition of interests in partnerships and S corporations (i. e. , pass- through entities) is excluded, but “only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest. • Since only net gain or loss attributable to property held by the entity which is not attributable to an active trade or business is taken into account, gain must be isolated for purposes of classification as NII or not NII.