Self-Rental Regulation Upheld Again



Taxpayers can deduct passive losses only to the extent they have passive income. If a taxpayer rents property to his or her wholly owned corporation, IRC section 469 generally categorizes this as a passive activity. However, when a taxpayer materially participates in the wholly owned corporation, Treasury regulations section 1.469-2(f)(6) recharacterizes the net rental income as nonpassive (the so-called self-rental rule). Transitional guidelines provide relief from this rule for rental agreements entered into before February 19, 1988. When a taxpayer rents property to one wholly owned corporation and another property to a different wholly owned corporation, regulations section 1.469-4(c)(1) allows the taxpayer to treat both rentals as one activity.

Thomas Krukowski was the sole shareholder of two C corporations, a health club and a law firm. He materially participated in the law firm. Krukowski owned two buildings he rented to the two corporations. The law office lease was signed in 1987 with a renewal option the firm exercised in December 1991. On their 1994 joint tax return, the taxpayer and his wife reported a passive loss of $69,100 from the building they rented to the health club and $175,149 of passive income from the building rented to the law firm. The return showed net passive income of $106,049. The IRS recharacterized the $175,149 of rental income from the law firm property as nonpassive based on the self-rental rule. As a result it disallowed the $69,100 passive loss from the health club building because the taxpayer did not have any passive income.

The taxpayer challenged this finding and the dispute reached the Tax Court. Taxpayer Krukowski made three arguments:

The self-rental regulation is invalid. Since sections 469(c)(2) and (4) specifically state that rental activities are passive, the Treasury secretary overstepped his authority when issuing the self-rental regulations.

The self-rental regulation did not apply because the lease was in effect before February 19, 1988. Leases in existence before this date were exempt from the self-rental rule.

Under proposed regulations available to taxpayers for 1994, shareholders could not participate in the activities of a C corporation. Therefore, the IRS reclassification of the $175,149 rental income as nonpassive was improper.

The Tax Court rejected all three arguments. The Krukowskis appealed the decision to the Seventh Circuit Court of Appeals, which had previously rejected the third argument in another case, Connor v. Commissioner, 2000-2 USTC 50,560.

Result. For the IRS. The Seventh Circuit agreed with the Tax Court that the self-rental regulation was valid. In the circuit court’s opinion, section 469(l) gave the secretary the authority to classify otherwise passive income as nonpassive to meet the congressional goal of eliminating tax shelters. The Seventh Circuit joined the First and Fifth circuits in upholding the validity of the self-rental regulation. ( Sidell v. Commissioner, 2000-2 USTC 50,751; Fransen v. United States, 99-2 USTC 50,882.)

The Seventh Circuit also agreed the lease was not eligible for transitional relief since it was not in effect before February 19, 1988; under Wisconsin law, the exercise of the renewal option constituted a new lease entered into in 1991. In their appeal, the taxpayers also had argued that regulations section 1.469-4(c)(1) allowed them to treat both rentals as a single activity. The Seventh Circuit disagreed since the taxpayers had not clearly indicated on their 1994 return their intent to treat the rentals as a single activity.

The outcome of this case further strengthens the validity of the self-rental regulations. It also shows the importance of clearly indicating on a tax return the taxpayer’s intent to make a valid election.

Krukowski v. Commissioner, 2002-1 USTC 50,219.

Prepared by Charles J. Reichert, CPA, professor of accountancy, University of Wisconsin, Superior.

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