Self-Rent and Passive Losses

Since the enactment of the passive loss rules in 1986, taxpayers have sought ways to produce passive income so they could claim otherwise denied passive losses. The Treasury Department issued regulations to deter some obvious schemes. One regulation deals with self-rent activities. Recently the courts evaluated its validity.

Chester Sidell was the sole shareholder of KGR Industries, a C corporation. To meet KGR’s expansion needs, Sidell purchased and rehabilitated a historic property. He rented it to KGR and claimed the rehabilitation tax credit against the rental income. The IRS reclassified the rental income as nonpassive and denied the credit. The Tax Court upheld the denial and the taxpayer appealed.

Result. For the IRS. The taxpayer’s main argument was that the self-rent rule in Treasury regulations section 1.469-2(f)(6) was invalid to the extent it covered C corporations. He argued that congressional intent was to limit the regulations to reclassifying income of pass-through entities only.

Regulations section 1.469-2 (f)(6) reclassifies as ordinary any net rental income from a lease of property to an activity in which the taxpayer materially participates. Regulations section 1.469-4(a) defines taxpayer activities as including those conducted by C corporations as well as pass-through entities. Both regulations were issued under IRC section 469(l), which authorizes the Treasury to issue regulations to carry out the passive loss rules.

The First Circuit Court of Appeals noted that because the regulations are legislative—written under a specific delegation of authority to write guidance—they can only be invalidated if the court determines they are “arbitrary, capricious or manifestly contrary to the statute.” Since section 469(l) authorizes the Treasury to issue regulations that reclassify income as nonpassive for both limited partnerships and other activities, it is clear that Congress intended C corporations to be included in the reclassification. In other words, the regulations are neither arbitrary nor beyond the scope of the statute. They are valid and the taxpayer must reclassify the rental income from a lease to a C corporation as nonpassive.

The taxpayer’s second argument was that the IRS should not have applied the regulations to his transaction. He argued that he was governed by earlier temporary regulations, which did not include C corporations. Although the Treasury had issued proposed regulations at the time of the transaction, Sidell argued he was entitled to rely on the older (temporary) ones since the proposed regulations did not specifically state that the prior exclusion of C corporations had been repealed. As authority for this argument, Sidell cited the dissent in Krukowski , a Tax Court case. The First Circuit rejected this argument. The proposed regulations did not have to specifically revoke an expired temporary regulation. They were sufficiently different from the temporary regulations to put the taxpayer on notice that the rules had changed.

By rejecting both arguments, the court established the self-rent rule applied to all types of organizations in which a taxpayer materially participated. It also rejected any attempt to apply prior rules because the current version did not specifically identify the changes. All future taxpayers will have to reclassify self-rent activities described in the regulations. In addition they should not attempt to apply temporary regulations after proposed regulations are issued where the proposed regulations are different.

Chester F. Sidell v. Commissioner, 225 Fg3d 103, 86 AFTR2d 6229 (CA-1).

Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.