As part of the Tax Reform Act of 1986, Congress enacted Sec. 469, limiting passive activity losses (PALs). As a general rule, PALs can only be offset against income from other passive activities; such losses cannot be offset against nonpassive income, such as dividends, interest, wages or most Schedule C income. Passive activities are those from activities in which the taxpayer does not “materially participate.” Temp. Regs. Sec. 1.469-5T contains detailed tests for what constitutes material participation. Under Sec. 469(c)(7), rental real estate is defined as a passive activity, regardless of the level of participation. PALs that cannot be used in the current tax year (due to an absence of income from other passive activities) are suspended until later years, when the taxpayer either has sufficient passive activity income or disposes of the activity that generated the losses in a taxable transaction. Because the application of Sec. 469 can be complex, Congress gave the IRS the authority to issue regulations under the PAL rules (Sec. 469(l)).
As a result, taxpayers who have incurred losses from rental activities often search for ways to generate passive activity income to offset their otherwise nondeductible PALs. A recent case from the Ninth Circuit discusses a technique commonly used to deal with this situation.
Gary and Dolores Beecher each owned a C corporation engaged in automobile repair and refurbishment. The Beechers conducted the business of the two corporations out of their personal residence; the two corporations paid the Beechers monthly rent for this office space. In addition, the taxpayers owned five (passive) rental properties that generated operating losses. The couple used the operating losses from the rental properties to offset the corporate rental income on their individual returns; as a result, they paid no income tax on the corporate rental income.
The Service disallowed this treatment, stating that although rental income is generally characterized as passive, such income was nonpassive under the “self-rental” rule in Regs. Sec. 1.469-2(f)(6). The IRS argued that the couple materially participated in the business activities of the two corporations. In essence, the regulation provides that when a taxpayer rents property to his or her own business, the income is not passive activity income.
Holding: The Service prevailed in Tax Court, and the Beechers appealed to the Ninth Circuit. They argued that Congress’s delegation to the IRS of the authority to issue regulations under Sec. 469 and, in particular, regulations dealing with the self-rental rule, was unconstitutional; the court categorically rejected this contention. It also rejected the taxpayers’ argument that, even if the self-rental rule is valid, it should not apply to them, because the PAL rules of Sec. 469 were enacted specifically to combat “abusive” tax shelters and should not apply in bona-fide business situations such as theirs; see Beecher, 9th Cir., 3/23/07, aff’g TC Memo 2004-99.
It is quite common for closely held business owners to lease real estate or personal property to their businesses. Such rental allows the owners to take money out of the business in a way other than as salary or dividends. If they use the rental income to offset real estate PALs, they will expose themselves to possible disallowance under the self-rental rule. In addition, if the amount of the rent is not considered to be arm’s length (i.e., it is excessive), the IRS may attempt to reclassify such excess as additional salary or even as a nondeductible dividend. Owners should consult their tax advisers before making such rental arrangements.