IRC section 469 states that a taxpayer can use losses from a passive activity only to offset passive activity income. In other words, passive losses cannot shelter active income such as salaries, commissions, wages or portfolio income such as interest, dividend or annuity income.
Under IRC sections 469(c)(2) and (c)(4), income from rental real estate is generally considered passive activity income, regardless of the taxpayer’s level of involvement in the property. However, the recharacterization or self-rental rule of regulations section 1.469-2(f)(6) provides that rental realty income is not passive activity income if the property is rented for use in a trade or business in which the taxpayer materially participates. This rule prevents a taxpayer with passive activity losses from artificially creating passive activity income to absorb the losses.
In Krukowski v. Commissioner (114 TC no. 25), the taxpayer was the president and sole shareholder of two C corporations. One corporation operated a health club; the other a law firm for which he worked as an attorney. Each corporation rented its respective building from the taxpayer. The original five-year lease to the law firm was signed in 1987. In 1991 the lease was renewed for another three years.
In 1994, the taxpayer reported a $69,100 rental loss from the health club and $175,149 in rental income from the law firm. On his 1994 federal return, he treated the two rentals as separate passive activities and offset the passive activity loss from the health club against the rental income from the law firm; he reported total taxable rental income of $106,049.
On audit, the IRS disallowed the offset and recharacterized the rental income from the law firm as nonpassive under regulations section 1.469-2(f)(6) because the taxpayer materially participated in the firm.
The taxpayer argued that this rule was arbitrary and contrary to the code. The court sided with the government and found that the recharacterization rule was a proper regulation.
The taxpayer also argued that regulations section 1.469-11(c) prevents the recharacterization rule from applying to contracts executed before 1988. The court agreed with the taxpayer, but found that based on state law the 1991 lease renewal was not an extension of the 1987 lease but a separate lease contract.
Observation. This case confirms the validity of the 1994 regulations that recharacterize self-rental income from passive to active when a taxpayer materially participates in a C corporation. However, if a taxpayer can show that, based upon applicable state law, a post-1987 lease renewal is an extension of a pre-1988 lease, and not a new contract, then the recharacterization rule can be avoided.
—Michael Lynch, Esq.,
professor of tax accounting at Bryant College,
Smithfield, Rhode Island.