A taxpayer’s passive losses can be deducted only to the extent of passive income. Under § 469(c)(2), any rental activity is considered passive unless, during the year, the taxpayer materially participates in a real property trade or business and performs more than 750 hours of personal services, which represents more than 50% of the personal services the taxpayer performed in all trades or businesses. Also, an activity is nonpassive if, under a lease entered into after Feb. 18, 1988, the taxpayer rents property to a trade or business in which the taxpayer materially participates (self-rental rule). Taxpayers may deduct passive losses up to $25,000 from a rental real estate activity if the taxpayer owns at least a 10% interest and actively participates in the activity. The entire $25,000 limit is available only when adjusted gross income (AGI) is less than $100,000, and is gradually phased out as AGI increases to $150,000.
In one case, Carolyn Fenderson owned 10 rental housing units, which generated an aggregate loss of $57,906. In 2005 she submitted an amended 2002 return listing the rental income and deductions on Schedule C. She had no other passive income, and her AGI was above $150,000. So, to deduct the $57,906 loss, it was necessary to treat the activity as a nonpassive real property trade or business. The Tax Court scrutinized her calendar records and allowed only 759 of her claimed 1,062 hours of personal service for the rental activity, versus 780 hours on her other job as a software sales account manager. Thus, the activity failed the 50% test.
In the other case, a partnership in which Gregory Farris had a 50% interest rented three buildings in 1985 to his law firm (also a partnership). A new lease was executed in 1990 due to the destruction of the original document; another was executed in 1992 due to the incorporation of the law firm. Yet another new lease was executed in 2000 when Farris became the sole owner of the rental property. In 2000, 2001 and 2002, Farris claimed that net passive income from the property of $34,839, $46,168, and $48,391, respectively, enabled him to deduct equal passive losses. The IRS disallowed the loss deductions, claiming he had no passive income against which to offset them, since the self-rental rule recharacterized the rental income as nonpassive.
Farris argued in Tax Court that the lease in effect during 2000 to 2002 was simply a continuation of the 1985 lease which, if accepted by the court, would exempt the income from being recharacterized as nonpassive. The Tax Court held the lease could not be a continuation because neither of the parties to the 1985 lease was a party to the 2000 lease. Any attempt to consider the law corporation to be a continuation of the law partnership would be at odds with both federal income tax law and state law.
The two cases illustrate how the classification of an activity as passive or nonpassive can be a double-edged sword. When taxpayers have income from activities that are passive, another activity with a loss needs to be passive to get a current deduction. However, when taxpayers do not have any other passive income, an activity with a loss needs to be nonpassive to receive a current deduction.
Carolyn D. Fenderson v. Commissioner , TC
Summary Opinion 2007-191
Gregory J. Farris v. Commissioner , TC Summary Opinion 2007-192
Prepared by Charles J. Reichert , CPA, professor of accounting, University of Wisconsin–Superior.