Prior to the vendetta against tax shelters in the 1980’s, distinguishing income by type gained little traction with taxpayers, tax planners and the IRS. However, with the advent of the “passive loss rules”, income was promptly categorized as, active income, passive income or portfolio income. Subject to certain statutorily defined exceptions which are outside the scope of this web piece, rental activities are classified as per se “passive.” If you have questions about whether or not you may fit within the sharply defined exceptions to this “per se” rule, contact your H&M tax advisor for assistance.
The passive loss hurdle:
On an ongoing basis, passive losses are deductible only to the extent of a taxpayer’s passive income. In short if you have passive losses and no passive income, those losses are suspended until you either dispose of the rental activity or secure a source of passive income. Contact your H&M tax advisor for assistance with suspended passive losses.
The ingenuity of taxpayers:
Confronted with unyielding passive loss rules, taxpayers sought to overcome these “anti-tax shelter” rules by creating (a) certain significant participation passive activities (“SIPPA”), (b) rental of non-depreciable property activities, (c) equity-financed lending activities, (d) property rented incidental to a development activity, (e) property rented to a non-passive activity of the taxpayer and (f) pass-through licensing intangible property in which the taxpayer acquires, each of which is intended to create passive income which allows the taxpayer’s passive loss deductions.
These enumerated activities are collectively referred to as Non-shelterable Passive Activities (“NOPA”). An exposition of each NOPA “activity” exceeds the scope of this website piece. Consequently, this piece focuses exclusively on the “property rented to a non-passive activity of the taxpayer” variety; and, admonishes readers to contact your H&M tax advisor for determining if you’re engaged in other NOPA varieties.
The Government response to “ingenuity”:
Before addressing the IRS response to this “ingenuity”, consider what happens if the rental profit isn’t “passive”. First, the other passive losses remain suspended. Second, the rental income is recognized by the lessor. Third, the previous two events essentially negate the rent deduction with the active profitable lessee. Fourth, the rental income may be subject to self-employment taxes. It’s obvious that upsetting taxpayer ingenuity has some fairly draconian consequences.
Property rented to a non-passive activity of the taxpayer (i.e. “self-rental”):
In short, self-rental occurs where a taxpayer leases an item of property to a lessee for use in a “trade or business” in which the taxpayer materially participates. If the self-rental activity produces a “loss” it retains its passive character, but if it produces a “profit” the profit is treated as “not passive”. The lessee entity can be pass-through entities (i.e. S corporations, limited liability companies and partnerships) and C corporations, whether or not they are PHCs or CHCs.
While the concept of material participation respecting pass-through entities is a common determination, the idea of material participation in a C corporation is more contorted. Essentially, while no income passes-through to C corporation shareholders, for NOPA purposes if the “shareholder participation in the C corporation’s activity is “material” then the NOPA rules apply.
Interestingly, material participation is imputed between spouses, but not between other family members suggesting a means of avoiding NOPA, subject, of course to other traditional “related party” rules.
It’s a safe assertion that NOPA as applied to “self-rental” arrangements is frequently overlooked by taxpayers. Nevertheless, as IRS audit policies increasingly focus of passive loss rules, the current sense invincibility will move from ill-advised to tragic. If you have any concerns relative to “self-rental” activities or other NOPAs, your urgent attention to these matters is critical. H&M tax advisors are waiting to assist you.