Tuesday, November 15, 2016
One of the issues that has generated numerous questions at the tax schools this fall has involved rental real estate income and the possibility of the recharacterization of those rents as non-passive. The questions have been primarily associated with farmland rental income, but not exclusively so. What is involved are the passive loss rules and the ability to avoid them by recharacterizing passive rental income as active income so that it fully offsets losses from other activities. With many ag producers sustaining large losses again this year. The passive loss rules and recharacterization are important.
Today, we take a look at the issue and why it matters.
Passive Losses – What Are They?
The passive loss rules of I.R.C. §469 were enacted in 1986 to reduce the possibility of offsetting passive losses against active income. The passive loss rules apply to activities that involve the conduct of a trade or business and the taxpayer does not materially participate in the activity or in rental activity on a basis which is regular, continuous and substantial. If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains).
Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. If an individual can satisfy the material participation test, the person is able to deduct passive losses against active income. If, for example, a physician is materially participating in a farming or ranching activity, the losses from the farming or ranching activity can be used as a deduction against the physician's income from the practice of medicine.
An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.” In determining whether an individual taxpayer materially participates (or actively participates), the participation of the taxpayer's spouse is taken into account, whether or not they file a joint income tax return. In addition, the governing statute refers to material participation by the taxpayer, but does not specifically bar imputation of the services of an agent or specifically embrace I.R.C. § 1402, which does bar imputation of activities of an agent to a principal. A Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and no individual performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer. The regulations provide seven tests for material participation. I won’t get into those tests in today’s post in order to keep the post relatively short.
If none of the material participation tests can be satisfied, there is a fallback text of active participation. More on that test in a moment.
The Recharacterization Rule
In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469. But, there are a couple of major exceptions to this general rule. Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Treas. Reg. §1.469-2T(f)(3). What this exception does is result in the conversion of rental income (and any gain on disposition of the activity) from passive to portfolio income. But, that is only the result if there is net income from the activity. If the activity loses money, the loss is still passive. That’s all fine and dandy you say, but how does this apply to me? Well let’s take an example (thanks to Chris Hesse of CLA for providing the general framework for the examples in today’s post):
Jack is a lawyer in the big city. He is involved in multiple investment activities that have suspended losses (losses that he couldn’t deduct in prior years and have been carried over to later tax years). Jack is in a tax position where the use of the losses would be valuable to him. On the advice of his accountant, and to help his father and brother who are having some difficult financial times, Jack buys 500 acres of land from his father for $400,000. Jack allocated $100,000 of the purchase price to depreciable items – fences, drainage tile, grain bins, etc., and cash leased the 500 acres to his brother. Because less than 30 percent of the purchase price is allocated to depreciable property, the cash rent that Jack receives from his brother is recharacterized as portfolio income in Jack’s hands. The rental income may not offset Jack’s suspended passive losses from his investment activities, but if the cash rent of the farmland produces a net loss after taxes, interest and depreciation, the loss is a passive loss. In addition, the cash rent income will be subject to the additional 3.8 percent net investment income tax even though it has been recharacterized as portfolio income (which is generally taxed at ordinary income rates).
Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, if a loss occurs, the loss is passive. For example, consider the following:
Ralph began farming in the 1960s and was encouraged in the 1970s to put his farming operation in a corporation. He did so, and is the sole shareholder of the corporation. However, Ralph retained personal ownership of farm buildings, a machine shed and some livestock facilities. He leased all of these personally retained assets to the corporation. Ralph reports the rental income on Schedule E and then it is carried directly to Ralph’s Form 1040 because the rental income is non-passive. Ralph would get the same tax treatment if leased the assets to a business in which his wife materially participates. There is a spousal rule that produces that result. I.R.C. §469(h)(5). However, in either situation, the income is still considered to be “rent” that is subject to the 3.8 percent NIIT.
So why does this rule matter? If a taxpayer has other passive losses, those losses can be offset with passive income. But, the rule works to recharacterize what normally would have been passive income to non-passive. Thus, the passive losses could not be offset.
While various rental activities can be aggregated for purposes of meeting the material participation test under the passive loss rules, it actually may not advantageous to do so. As noted above, rents are passive, but if the taxpayer is a real estate professional, rents are not passive. A real estate professional is one who puts more time into rental activities than in non-rental activities and more than 750 hours in the rental activities in which the taxpayer materially participates. For a real estate professional, rents are not passive. Also, rental activities could be grouped together to meet the material participation test under I.R.C. §469. But, if rental activities are grouped instead of each rental activity being a separate activity, lost is the ability to claim suspended losses on the disposition of any single rental activity.
Mitigating against aggregation is the 30 percent rule mentioned above which makes the net rental income non-passive, and the self-rental rule that recharacterizes passive rents to non-passive. In any event, the self-rental regulation takes precedence over a grouping election. Carlos v. Comr., 123 T.C. No. 16 (2004). But, remember, if the rental activity loses money, the losses are passive. Those losses will likely end up suspended. However, remember that fallback test of active participation mentioned earlier? That rule allows individuals to offset losses from rental real estate without necessarily having passive income. I.R.C. §469(i)(8). Under this rule, a taxpayer can deduct up to $25,000 in rental real estate losses if the taxpayer actively participates and modified adjusted gross income is $100,000 or less. At $150,000 of MAGI, no deduction is allowed. Active participation is a much less rigorous test to meet than is material participation.
Also, it’s not possible to aggregate self-rentals. Consider the following:
John and Marcia operate their overall farming operation as an S corporation. They materially participate in the farming operation. They have two tracts of farmland. During 2016, the income from one tract showed net rental income and the other tract showed a net loss. The two rental activities would not be able to be grouped together. The self-rental property with net income is recharacterized as non-passive, but the other rental activity remains a passive loss. So, the income from the one tract cannot offset the loss from the other tract. Instead, the loss is a suspended loss. However, they could group their rental activities with the S corporation farming business to get around the bar on grouping self-rentals. That would allow the full deductibility of any losses.
The example points out that a business activity can be grouped with a rental activity. That is the case if each owner has the same proportionate ownership interest in the rental activity and the business activity. Also, a rental activity can be grouped with a business activity if the rental activity is “insubstantial” in relation to the business activity. What that accomplishes is that the rental activity is not passive if the owner materially participates in the business. Unfortunately, there is no precise regulatory definition of “insubstantial”. However, court decisions have allowed grouping when the rental property is leased to the business activity and when the gross receipts of one activity (usually the rental) are insubstantial (generally less than 10 percent of total gross receipts). See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 174242 (W.D. Ark. Nov. 12, 2015).
It’s also not possible for a real estate professional to group a rental real estate activity with another type of real estate activity. Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016).
In addition, there are disclosure rules that apply to groupings, and special rules apply to groupings by pass-through entities.
The passive loss rules can be confusing and the grouping rules complicate matters. But, the proper use of the rules can provide a good tax result as they are incorporated with other tax planning moves for taxpayers.