Discussion:Self-Rental Passive Losses and Gains

T/P's own some land and want to construct a new building on the property for the lawn mower business.Their plan is to set-up an LLC and elect to be taxed as a partnership. Ownership will be 50/50. The land that they presently own will be transferred into the partnership. At the end of the day the partnership will own the land and the building.The partnership will then rent the land and building back to the Sub-s Corp.

The partnership will be a passive activity whereas the lawn mower business will be a nonpassive activity. The husband and wife will actively participate in the operation of the rental property.

From my research, net rental income Reg. 1.469-2(f)(6) is treated as not from a passive activity. This income will then flow to the T/P's 1040 and be omitted from Form 8582.It can not be used to offset net rental losses.

If there is a net rental loss of the partnership- my thinking is such: The passive loss of the partnership will flow through from the K-1 and be reported on the T/P's 8582 as an unallowed suspended loss. The loss and any other subsequent losses (of the partnership) will just build over time or until the T/P's have passive gains from another'different activity' other than the partnership to net against or dispose of the property.

Appreciate your insight.

"(f)(6) 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 (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469–5T) for the taxable year; and (ii) Is not described in §1.469–2T(f)(5)."

This is the provision that says what you said, "It can not be used to offset net rental losses" in the situation you've got with the lawnmower repair building. We called this rule the "Heads, IRS wins, Tails, Taxpayer loses" regulation. If it's a loss, it's passive, but if it's income, it's non-passive.

If there are also "prior court cases" that ruled on this question, too, as Larry0434 says, I don't know of them. But that's not very special, considering all the things that I don't know of. See how far I will go to make sure that a preposition is what the sentence ends with?

However, if the ownership percentages in the S corporation are the same as the ownership percentages in the partnership, then the losses will not necessarily be passive.

How come? I don't follow. I'da thunk that passive would be the general rule [rental = passive] with in this case the exception for when you work where you rent from yourself, the rental *income* - if income - is non-passive, because of the "heads they win, tails you lose" rule.

Is there an exception-to-the-exception?

Thanks for all your input.

Per my original question:

I have researched and determined that a suspended loss by the rental partnership activity in year 1 can be used to off-set net rental income of the activity in year 2.

Per my original question:

If there is a loss on the part of the partnership rental activity in year 1-would this qualify for the $25,000 loss allowance rule of Code Sec 469(i)?

But to answer you last question, yes, if there is a passive rental loss, it would qualify for the $25k passive loss allowance rule.

At this point though - I do not agree with Paul's statement "I have researched and determined that a suspended loss by the rental partnership activity in year 1 can be used to off-set net rental income of the activity in year 2."

because: if the rental activity generates net rental income - this activity falls under the self rental rules - it then is not passive income.

If I am wrong on this, I have no problem with someone kindly (note I said kindly - you know - like how Riley2 points things out) spelling out why my thinking is incorrect. Always interested in learning as are all the others who read these posts and do not actually comment.

This now seems to agree with Paul's last post/research as well as your last post, although as my comments relate to Form 8582 from Paul's original post - it is different.

No grouping issue involved (does not apply in this specific situation i.e. rental 100% owned - active business 99% owned)- just former passive activity and current year non passive (rental) income due to reg 1.469-(2)(f)(6). Pursuant to sec 469(f)(1)(A) we can offset the current year net (non-passive) rental income with the prior years "unused deduction allocable to such activity" or prior years c/f passive losses related to this single activity - no other activities allowed in this calculation. If the current years net income is less than the prior years unused passive losses, this is all done on Form 8582 and then reported as such on Schedule E. Any remaining passive losses are c/f to the next year pursuant to sec 469(f)(1)(C) and we go through the same calculation again if in the following year we again have non-passive (rental) income. If in the following year we incur a rental loss - it again is classified as a passive activity loss.

http://www.irs.gov/businesses/small/article/0,,id=146847,00.html

Roy - if you go to page 6 of the instructions of Form 8582 and read the section on "Former Passive Activities" - this seems to conflict with the Passive Activity Loss Audit Technique Guide section you have linked. It seems to conflict under "Adjustment - second, third and fourth sentence - 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 "

In Michaelstar's situation, I believe that only the passive losses in excess of current year income should appear on Form 8582.

If my conclusions above are correct - which I believe allow me to offset the Reg 1.469-(2)(f)(6) non passive income with prior year passive losses under sec 469(f)(1)(A) (from the same rental activity only)- how does this flow through Schedule E? The deduction under sec 469(f)(1)(A) does not appear to flow though to line 23 of Schedule E.

Riley2 - I understand what your saying now "that only the passive losses in excess of current year income should appear on Form 8582" which when reading the word problem of the PAL Audit Technique Guide (Exhibit 3.2)- seems to imply. sidebar - Why they need to be so cryptic is beyond me.

What puzzles me - if my conclusion is correct - how does it flow though to Schedule E? Line 18 as an "other"?

Edit - really think the passive loss allowed needs to flow to line 23 but just not sure at this point.

What is the right answer? you ask. Oh, damn, I was hoping you wouldn't go there. There's still a coupla PBRs in the fridge. It's Sunday and the Beer and Wine store won't be open for another hour.

Please note that the a passive loss for a prior year, and you can only have a passive loss from the prior year (not before), is a deduction in the current year for that activity on Schedule E. Therefore when the term "self rental current year income" is used, it is after the deduction for the prior year passive loss carryforward. Also, the term current year passive rental loss includes the amount of the prior year passive loss carryforward as a deduction.

If there are more questions please ask.

The amount of net self-rental income for the current year is determined after the passive loss deduction from the prior year, grouped or not grouped.

I did not see where the prior year passive loss carryforward is not allowed as a deduction in the current year.

I may wrong or incorrect, but, there is a different idea as to the problem on the table.

See Pub 925...

Does this apply to the OP's proposed rental of the bike shop premises? Where's the definition of "related party transaction"?

I have spent the better part of last night and today further reading and rereading and quite frankly have not come away with anything additional to add except the form instructions to not full address this issue.

Roy - I have read pub 925 and the pub itself just skims this self rental issue and the rental income that is recharacterized under reg 1.469-2(f)(6). I have also gone to RIA and their Federal Tax Coordinator section and again come away with - yes - this can be done but no place have I found clear guidance on how it flows through to Schedule E. I am now almost quite certain - the prior year's unallowed passive losses do not flow to line 23 of schedule E.

I have called the IRS tax law group and have had it written up for further discussion and comments with them. I will follow up with what I find out and go from there.

Certainly any more comments on the subject will be helpful.

Blrgcpa - I do tend to agree with Harry. I am not sure how "related party transactions" enters into this as we are not discussing a disposition but the reporting of an ongoing activity. If there was disposition of the activity to an unrelated third party, I still believe that all prior years unused losses would be currently deductible.

"Passive activity deductions include all deductions from activities that are passive activities for the current tax year and all deductions from passive activities that were disallowed under the passive loss rules in prior tax years and carried forward to the current tax year."

"Treatment of former passive activities. A former passive activity is an activity that was a passive activity in any earlier tax year, but is not a passive activity in the current tax year. You can deduct a prior year's unallowed loss from the activity up to the amount of your current year net income from the activity. Treat any remaining prior year unallowed loss like you treat any other passive loss.

 In addition, any prior year unallowed passive activity credits from a former passive activity offset the allocable part of your current year tax liability. The allocable part of your current year tax liability is that part of this year's tax liability that is allocable to the current year net income from the former passive activity. You figure this after you reduce your net income from the activity by any prior year unallowed loss from that activity (but not below zero)."

I read the foregoing to say about self-rental:

1. Self rental income is determined after taking the deduction for the prior year's unallowed loss. If, after that deduction you have net income it is treated as non-passive. If, after that deduction you have a net loss it is treated as passive.

2. If, there is no prior year loss deduction, and you have net rental income it is treated as non-passive, and a net rental loss is passive.

Comments are welcome.

Going back to pub 925 (page 2 - "treatment of former passive activities") and all that the pub states is what you have quoted above for all others to also read - I interpret that to state that the prior year's (that is from all prior year's being c/f) unused passive losses is/are a Schedule E, line 18 item up to the rental net income but not below zero. Granted, the pub does not specifically reference Schedule E and line 18 but where else could it go?

Bottom line, to be wrong in how this is included on the forms and have my client pulled for audit over this issue because some large number on the wrong line number would not be a good thing (for me).

Note Form 8582 instruction are not relevance in determined whether there is self-rental loss or not. They cover how to handle the situation after the determination has been made.

All comments are welcome.

I have also been reading the comments by the various participants in this discussion and have also looked over the forms, instructions and the code. If any thing the instructions are not clear but I do find the Passive Activity Loss ATG-Exhibit 3.2 referenced on 5.27.2009 clear and the basis of Michael's input.

However, I found an interesting article in The Tax Advisor (AICPA) of August, 2008 "Avoiding the Self-Rental trap" On page 2 Trap 1-Trapped Losses. The author more than suggests that the active income can be used to off-set cf passsive suspended self-rental losses and that self-rental active income in year 2 would be allowed for Line 1a of Form 8582.The self-rental income cannot off-set losses from other activities.

This is not in agreement with ATG-Exhibit 3.2 which leads me to believe that the exhibit is unclear.

I am in agreement with you on your comment of ATG-Exhibit 3.2. I also brought this up yesterday with the law section of the IRS and am now in a hold pattern until I get a call back.

Are you in agreement with my question regarding the $25,000 passive loss allowance?

Now I am adding my own slant in saying that if your client did not pay FMV rent to the partnership for use of the property then while I still believe sec 469(i) would apply, there could be a possibility that some of the loss would be disallowed if FMV rents were not paid. Would not make any sense for your client to not pay FMV rents in this case as they own both businesses as per your original post. I am sort of pulling concepts from sec 280A into this which may be incorrect but it is something to at least consider when your client considers what to charge the business for rent.

Another recent ruling regarding "Grouping Activities" (Self-Rental) is referenced below: Apr 16, 2009 ... C.A. Senra, TC Memo. 2009-79, Dec. 57789(M). Other References: Code Sec. 469. CCH Reference - 2009FED ¶21966.53 ...

After you read-what are your thoughts. Almost appears that Grouping Activities is unattainable.

"The amount of net self-rental income for the current year is determined after the passive loss deduction from the prior year, grouped or not grouped." Quote from above.

In other words, the self-rental activity stands alone to determine if it is passive or not.

After all the research I have done as well as others (great links Roy) here inside this post up to this point, I can not see any other "path" to take. Cal Interiors and Carlos are not on point to my situation but address another issues of the self rental rules. I have yet to see a court case where what we have concluded about a single activity has been addressed. Probably does not exist as it is probably unnecessary.

I am waiting for the IRS Law section to call me back on this and see what they have to say. I will report back once resolved.

This is just as Harry and I concluded above even though it does not specifically state this in any of the form instructions. The IRS agent stated that he had never had to research this issue up to this point and that one needs to inductively arrive at this conclusion from the form instructions. I agree.

After further reading on this issue, one should probably also look closely to reg 1.469-(2)(f)(9) in conjunction with reg 1.469-(2)(f)(6) for definitions.

I brought up this additional twist which the agent was unable to answer but I have concluded the following. If anyone else has some input to add, I am sure it would provide additional value to this very interesting post.

Lets say that one did not treat this activity as above and did not offset the unused passive losses against a single year's net income on Schedule E, line 18 and incorrectly treated that single year as non passive. Now that incorrectly treated recharacterized "non passive" year is now a closed year. Any passive losses that should have been used as a deduction, I have concluded are lost and the passive losses coming forward into an open year should be adjusted accordingly.

Adding a new twist to the post as you have of the activity being disposed of makes most of the aboves discussion a non issue.

(there is room for us both to be correct)

Your addition and point is quite correct if in fact a disposition were to occur. If a disposition were to occur, it would also then hold true that reg 1.469(2)(f)(6) would not as there is no passive income that would need to be recharacterized as non passive under this specific Reg.