Taxing Lessons From Court Decisions

Decisions — Taxing the Selfie

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Image source: By NASA/JPL-Caltech/Malin Space Science Systems. Derivative work including colour correction, correction of dark areas and vignette, denoising: Julian Herzog (http://photojournal.jpl.nasa.gov/catalog/PIA16149) [Public domain], via Wikimedia Commons
Image source: By NASA/JPL-Caltech/Malin Space Science Systems. Derivative work including colour correction, correction of dark areas and vignette, denoising: Julian Herzog (http://photojournal.jpl.nasa.gov/catalog/PIA16149) [Public domain], via Wikimedia Commons

You’ve heard, time and again, that rental activities are passive under the passive activity loss rules in internal revenue code section 469. That’s true, except when it isn’t.

Self-rentals are an exception to the general rule. The self-rental rule (Treasury Regulation 1.649-2(f)(6)) says that when you rent property you own to a business in which you materially participate, the rental profit is not considered passive. The exception exists because self-rental presents an opportunity to shelter income. You could rent a building you own to your business and charge enough rent to create a loss in your business. You could also apply the passive rental income against other passive activity losses.

That’s what the taxpayers in T.C. Memo. 2015-76 (Williams) did. The taxpayers owned commercial real estate property in a Subchapter S corporation. They were 100% owners of the S corporation. They were also 100% shareholders of a C corporation home medical equipment business in which the husband worked full-time. The taxpayers rented the commercial real estate in the S corporation to the medical equipment business. They reported the pass-through S corporation rental income as passive on their personal tax return and used it to offset other passive losses.

The IRS said the S corporation’s rental income was nonpassive under the self-rental rule. The IRS disallowed the passive losses in excess of the taxpayers’ adjusted passive income.

The taxpayers admitted the husband materially participated in the medical equipment business. However, they said the self-rental rule did not apply since the lessor (the S corporation owning the commercial real estate) did not materially participate in the trade or business of the lessee (the C corporation medical equipment business).

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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For the IRS.

Treasury regulation 1.469-2(f)(6) does not contain the words “lessor” or “lessee.” That regulation requires:

(1) property be rented for use in a trade or business and

(2) the taxpayer materially participate in the trade or business.

The first requirement is clearly met because the property owned by the S corporation was rented to the medical equipment business for use in its trade or business. The taxpayers admit the husband materially participated in the medical equipment business’s trade or business.

We find no authority in the plain language of regulation 1.469-2(f)(6) to support the argument that the lessor, as a legally distinct passthrough entity, must participate in the trade or business of the lessee.

The taxpayers, as individual taxpayers subject to the requirements of internal revenue code section 469, received passthrough income from property that was rented for use in a trade or business in which the husband materially participated.

Accordingly, the requirements of regulation 1.469-2(f)(6) have been met, and the income the taxpayers received from the rental of property by the S corporation to the medical equipment business must be recharacterized as nonpassive income, which the taxpayers may not offset with passive losses.

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