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HEADS THEY WIN, TAILS YOU LOSE IN PASSIVE LOSS RULES

November 15, 2007

About 10 seconds after President Reagan signed the passive loss rules into law in 1986, tax scientists began tinkering in their laboratories with "passive income generators," fondly known as "PIGs," to enable taxpayers to use passive losses that would otherwise be deferred.

As we discussed yesterday, the passive loss rules keep you from deducting losses from "passive" businesses, including most real estate rentals, except to the extent of "passive" income. Taxpayers who rented property to their controlled businesses swiftly raised their rental rates to themselves so that their properties suddenly produced taxable passive income, offsetting their otherwise deferred passive losses.

Gregory J. Farris and his law partner Mark Susi ran a real estate partnership that owned an office building in Gardiner, Maine. The partnership rented an office to the law firm of Farris and Susi. The lease coincidentally generated taxable income, which Mr. Farris treated as passive loss on his 1040 to enable him to offset other passive losses.

Unfortunately for Mr. Farris, the IRS long ago issued Reg. Sec. 1.469-2(f)(6), which says:

Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property --
(i) Is rented for use in a trade or business activity * * * in which the taxpayer materially participates (within the meaning of § 1.469-5T) * * * for the taxable year.

As the Tax Court explains,

Simply put, the regulation recharacterizes a taxpayer's rental income from property rented for use in a trade or business in which the taxpayer materially participates as nonpassive income and therefore not taken into account in the computation of the taxpayer's passive activity loss.

Mr. Farris argued that his lease was "grandfathered" under rules that applied to existing leases when the regulation was issued. The Tax Court didn't see things that way; to be grandfathererd, the lease had to be in place on February 19, 1988. Unfortunately, the law firm had been incorporated in 1992; it had operated before then as a partnership. The Tax Court said it couldn't therefore be the same lease, and the income couldn't be treated as passive.

The moral? If you want a lease to your own business to be a PIG, it needs to be an old PIG.

Cite: Farris, T.C. Summ. Op. 2007-192.

Tags: Farris.passive losses.