12 Nov Schumann v. IRS: Reg. 1.469-2(f)(6) – The Nuanced Relationship Between Passive Losses & Self Rental Gains
Schumann v. IRS: Reg. 1.469-2(f)(6) – The Nuanced Relationship Between Passive Losses & Self Rental Gains.
Back to my friends that I previously wrote about who misunderstood passive activity and material participation. They are a married couple filing jointly and own a very successful business together structured as an S-corporation as well as a portfolio of rental real estate properties.
They actually consider themselves privileged to have their their tax woes shared anonymously via this tax blog which is helpful as I appreciate any opportunity to share how real life scenarios are applied to the US internal revenue code.
One of the properties my friends own – titled in their personally names jointly – has as a tenant an S-Corporation in which they each also own 50% of the shares issued and outstanding. Basically they hold title to the rental property – a large office warehouse complex – and they own the corporation that rents the property.
Unfortunately this rental property generated net rental income in tax years 2010, 2011 and 2012 for my friends personally on IRS Form 1040 Schedule E. Interestingly enough the other rental properties in their portfolio rented to unrelated third parties collectively generated net rental losses for the same three tax periods.
Because my friends are not real estate professional nor did they materially participate in the rental activities where the tenants were unrelated third parties, they found themselves in a conundrum when examined by the IRS. Ultimately the tightly wound revenue agent was surprisingly bright enough to cite Douglas D Schumann, TC Memo 2014-138 in asserting that the losses from the rental properties to the unrelated third parties were considered to be passive and suspended as a result of high income and at the same time the income from the profitable rental involving the corporation owned by my friends could not offset passive losses because it was deemed a non-passive self rental.
HOW IS THIS POSSIBLE YOU MIGHT ASK?
Regulation 1.469-2(f)(6) states the net rental income from a self-rental property is considered to be non-passive when the property is rented to a business that the taxpayer also materially participates. Since the wife materially participates in the corporation the personal income generated from the rental to the corporation owned by the taxpayers was deemed a self rental subsequently making it non-passive and as such could not be offset by the losses from the other rental losses.
Basically a self-rental activity that results in a loss can be considered a passive loss subject to phased out passive activity loss limitations based on income. However self rental activity can also be subject to non-passive treatment when there is a self-rental gain.
THAT SUCKS! But it also creates many opportunities for strategic tax planning. Please feel welcome to contact me if you might be inclined to drill down.