Thursday, April 18, 2019
In recent weeks, I have written a couple of posts on various aspects of the passive loss rules contained in I.R.C. §469. Indeed, over the past two years, I have written six posts on the various aspects of the passive loss rules and their application to farm and ranch taxpayers. With today’s post, I add to those numbers by examining another aspect of the passive loss rules and how it applies to a common tax and business planning technique of farmers and ranchers – renting the farm/ranch land to the farm/ranch operating entity.
The “self-rental” limitation of the passive loss rules – it’s the topic of today’s post.
Passive Loss Rules - Basics
As noted in prior posts, to deduct passive losses (the amount by which the taxpayer’s aggregate losses from all passive activities for the tax year exceed aggregate income from those activities), an investor must have passive income. Stated another way, a passive activity loss can only offset passive income (with a few exceptions). The rule makes it quite difficult for a taxpayer to deduct passive losses unless they have another activity that is generating passive income.
Avoiding Passive Losses
Materially participate. There are two ways to approach the limitation of passive loss rules. One is to not be engaged in passive activities. A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. §469(c). Under the general rule, rental activities are passive. I.R.C. §469(c)(2). But, as noted in prior posts, there are exceptions. In addition, the activity is not a passive activity if the taxpayer is involved in it on a basis that is regular continuous and substantial. Basically, the taxpayer has to be involved in the daily management of the activity for a sufficient amount of time. The regulations provide seven tests for material participation. Treas. Reg. §1.469-5T(a)(1)-(7).
Create passive income and the risk of recharacterization. The other approach is be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses. This became known as the “slaughter of pigs.” There are ten categories of recharacterization.
Bare land leases. One recharacterization rule applies to bare land leases. Treas. Reg. §1.469-2T(f)(3). Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Id. The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive.
Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid. See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303.
Self-rentals. Farmers and ranchers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity. If the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, 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, just like the recharacterization rule mentioned above for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply. Treas. Reg. §1.469-11(c)(1)(ii). It’s not possible to renew or draft an addendum to the original lease and come within the exception. See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). It also applies to S corporations. Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76.
Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income.
It’s not possible to make a grouping election to overcome the self-rental regulation. See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). As I noted in a prior post on the passive loss rules, a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit. Treas. Reg. §1.469-4(c). But, even with such a grouping election the self-rental rule will still apply.
Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the IRS could separate the two rental tracts with the result that the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040.
One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity. Treas. Reg. §1.469-4(d)(1). In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity.
One more point on grouping – can a self-rental be grouped (“aggregated”) with the farming entity to maximize an I.R.C. §199A deduction? I.R.C. §199A is the new 20 percent deduction available for sole-proprietors and pass-through businesses on qualified business income. The answer is that as long as the farming entity and the land rental are part of a common group and have the same tax year, the rent will be aggregated with the farm income. That can optimize the use of the 20 percent deduction.
The passive loss rules are tricky. The cases are legion. Rentals are tricky, and the IRS can recharacterize rental activities to eliminate hoped-for passive income generators. Make sure you understand how the rules apply.