Case — Self-Rental Income

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TL Case Summ

THE QUESTION

Is income received from renting a personally owned commercial building to a related corporation passive or nonpassive?

THE DISPUTE

Taxpayer Says: The rental income is passive because the governing lease qualifies for an exception to the general rule.

Internal Revenue Service Says: The income is self-rental income, which is not passive.

THE LAW

From Internal Revenue Code Section 165(c)(1): Generally, a taxpayer may deduct a loss incurred in a trade or business.

From Internal Revenue Code Section 469(c)(2): Generally characterizes rental activity as passive.

From Federal Tax Regulation 1.469-2(f)(6): Provides that net rental income received by the taxpayer for use of an item of the taxpayer’s property in a business in which the taxpayer materially participates shall be treated as income not from a passive activity.

From Federal Tax Regulation 1.469-11(c)(1)(ii): Provides that, in applying section 1.469-2(f)(6) of the income tax regulations, a taxpayer’s rental income is passive if it is attributable to the rental of property “pursuant to a written binding contract entered into before February 19, 1988.”

THE CAUSE OF THE DISPUTE

When you own rental properties, the income or loss from those rentals is generally considered passive. Passive activity income and loss is subject to a special set of rules that can limit current year deductions.

For example, unless an exception applies, passive activity losses can only offset passive activity income. That means rental losses can’t be used to reduce your income from other sources, such as wages. Instead, passive losses in excess of your passive income are carried forward until you can use them against other passive income, or you sell or otherwise dispose of the activity generating the losses.

An exception applies when you rent property you own personally to a business in which you materially participate. In that situation, your rental income is considered nonpassive. These “self-dealing” rules prevent you from generating passive income that will offset other passive losses.

However, the self-dealing rules also have an exception, which allows you to treat rental income as passive if the income is paid under a lease that was in effect before 1988. (Editorial note: This was designed to ease the transition to the passive activity rules, which were enacted in 1986.)

In this case, the taxpayer, a doctor, personally purchased an office building in 1979. He prepared a lease in 1980 and began renting the building to his medical corporation. The lease provided for an annual rent, to be paid monthly, with an automatic increase in each succeeding year and an automatic renewal clause.

From 1980 through 2007, the taxpayer’s medical corporation wrote checks in varying amounts to the taxpayer, on no specific schedule, and with no notation as to what the payments were for. During the course of preparing the corporation’s income tax return at year end, the accountant allocated amounts paid to the taxpayer to various accounts, including rent. The corporation deducted the portion classified as rent, and the taxpayer included that amount on his personal income tax return.

For the years in question (2005 and 2007), the taxpayer used other rental losses to offset the rental income from the corporation on his personal return. He believed the rental income from the corporation was passive because it was paid under the 1980 lease, which qualified for the exception to the self-dealing rules.

The IRS says the rental income is nonpassive and cannot be reduced by other passive activity losses. While agreeing the 1980 lease was binding at the time the taxpayer entered into it, the IRS contends the lease was not binding in later years because neither the taxpayer, his corporation, nor his accountant paid any attention to the terms of the 1980 lease. They ignored the lease provision with respect to the amount of required rent, as well as the lease requirement that monthly rent payments be made and that the rent increase annually. Because the lease was a meaningless document, the rental income did not fall under the exception to the self-dealing rules and is nonpassive.

WHAT WOULD YOU DECIDE?

For the Taxpayer or for the IRS?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 32KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

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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Sorry, wrong answer :(
Right answer!
For the IRS. The taxpayer failed to prove the 1980 lease was still a binding contract under New Jersey law in 2005 and 2007. During 2005 and 2007, the taxpayer did not calculate the correct amount of rent due under the 1980 lease, and the medical corporation did not make the required monthly rental payments. The rental arrangement during those years was completely ad hoc – the accountant determined the rent after the fact on the basis of his analysis of the taxpayer’s financial situation at the time. The rental income reported on the 2005 and 2007 personal income tax returns is nonpassive income.
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