Ever since Code Section 469 hit the streets in the Tax Reform Act of 1986 it has trapped many unwary tax payers and practitioners. The mechanical nature of the rule subjects taxpayers and practitioners to significant risk of penalty for failure to adhere to the regulations. In a recent NSA ConnectED webinar, we reviewed and discussed examples of the 8 most common "traps" and how your client and you, the practitioner, can avoid them. Buy the on-demand webinar
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Here is a sample Self Rental ATG: IRS Passive Activity Loss Audit Technique Guide
Exhibit 3.2: Self-Rented Property - Income Recharaterization
ISSUE: Should net rental income for Property ____ be recharacterized as non-passive? When the taxpayer rents property to his own business, income generally is non-passive. In other words, should income be removed from Form 8582 line 1a, thereby reducing allowable passive losses?
NOTE: Net losses are generally passive under IRC § 469(c), even in a self-rental situation. Reg. §
1.469-2(f)(6) recharacterizes only net income.
_____ Did the taxpayer or spouse work in a partnership, LLC, S-Corporation or C Corporation, which leases its building or equipment from him? For partnerships and S Corporations where the taxpayer works, material participation can easily be determined by reviewing the income/losses on the back of Schedule E. Income/losses in the non-passive column means the taxpayer claims to have materially participated in the partnership or S Corporation. For regular C Corporations, check for a W-2 from the corporation which is an indicator of material participation and ask the taxpayer how much time he and his spouse spends on corporate activities. If the taxpayer is a corporate officer, check Form 1120, U.S. Corporation Income Tax Return, Schedule E (which appears on back of Form 1120), Compensation of Officers, for percentage of time.
_____ Is there a written lease signed before 2/19/88 which binds the year under examination? As a practical matter, there are very few leases executed before 1988, which would bind current years. See Reg. 1.469-11(c)(ii). If there is a lease, be sure to request it immediately to verify the date it was signed and that it binds the current year.
If the answer to first question is YES and answer to second question is NO, income is non-passive and should not be on Form 8582 line 1a.
LAW: Under Reg. § 1.469-2(f)(6), if a taxpayer rents property to a business in which he materially participates, net rental income is non-passive. Stated differently, rental income from self-rented property cannot be used to trigger allowance of passive losses on Form 8582. This rule does not apply if there is a written binding contract entered into before 2/19/1988.
CONCLUSION: Income in the amount of ___ has been determined to be non-passive and removed from Form 8582. Thus passive losses in the amount of ___ have been adjusted due to income recharacterized as non-passive.
ADJUSTMENT: Income is still reportable on Schedule E, but cannot be entered as passive income on Form 8582 line 1a. Remove self-rented income from Form 8582 and recompute. For every dollar of income removed from Form 8582, allowable passive losses generally are reduced a dollar. Passive losses are deductible only up to passive income reported on the return PLUS $25,000 in rental real estate losses. The difference between FORM 8582 line 16 per return and as corrected is your adjustment. The MAGI on Form 8582 will be increased by the amount of self-rented income determined to be non-passive. Thus, the taxpayer also may lose part of his $25,000 offset under IRC § 469(i).
References:
Self Rental Court Cases
Sidel v. Comm 1st Circuit
Self Rental Tax Traps: Are You in Danger? Are Your Clients?
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