We have had passive activity rules for over 20 years and passive income recharacterization rules for close to 15 years, and it is surprising that there is still a lot of confusion and bad advice out there. In paticular, self-rental income and recharacterization are a prime example – especially for business owners who lease real property to their business.
Let me setup a typical scenario to explain this:
Bob owns and materially participates in a successful contracting business organized as an S-Corporation, which leases a building and storage area owned by Bob personally. Bob has the building and storage facility setup in a single-member LLC, he has a written lease agreement, and he pays a reasonable amount of rent from the corporation to the LLC.
Now, Bob also has five residential rental properties that he reports on his personal return, and on average the properties turn net losses because of high turnover and the large mortgages on the properties. For simplicity sake, lets assume Bob has not filed any special elections and has an adjusted gross income over $150k.
Under passive activity income rules, the net losses from the rentals are not currently deductible on Bob’s individual tax return as he has no passive income to offset the losses and he is not allowed the special allowance of $25k in residential real estate losses because his AGI is over $150k. These losses carryforward until Bob has a good year and receives some passive net income from the properties or sells them – otherwise the losses are kept separate from from the income Bob receives from his S-Corporation.
This has been a frustration for many taxpayers who have plenty of net income from their main business that they have to pay tax on and passive net losses from rental real estate that they cannot deduct or offset against that taxable income. From 1987 to 1994, many taxpayers like Bob talked to their accountants and found that if they increased the rent the corporation paid them for the lease of the business facility, they could offset the net passive losses from the rental properties and essentially get to deduct all the losses against the active income from the corporation. This worked great and was a fairly strong strategy. Even shareholders who did not own property and only rented office space for their business would renew their leases in their personal name and them sublease to the corporation at a much higher amount – basically whatever was needed to cover the rental real estate losses.
However, this “loophole” was closed in 1994 by Regs. §§1.469-2(f)(6) and several court cases and “recharacterization” was officially born. For self-rented property where the property was rented to active business, the net rental income from that lease became active and not passive, which means that it could not be offset against other passive losses. For Bob in our example, this means that he cannot offset the net rental income from his facilities lease to the corporation against the passive losses from his residential rental properties. The once great strategy is no longer plausible and we are back to taxable income from the corporation and passive net losses that are not currently deductible.
Why do I bring this up 15 years later? Well, sadly many accountants and CPAs out there still use the pre-1994 strategy of offsetting the lease from the corporation against passive net losses from other rental real estate. Some are aggressive and put more merit in prior dealings with IRS auditors and their ability to argue, while others may just be careless and uninformed. Regardless, small business owners who also have rental real estate need to be aware of this issue and have a basic understanding of the rules as blaming your tax preparer is not going to get you off the hook with an IRS auditor. In fact, talk to your CPA or accountant, ask questions, and make sure you understand the positions taken on your return. Tax law is very complicated and often very dull, but in this case it is fairly clear and an incorrect position can result in a large IRS audit adjustment.
If you have any questions regarding your specific situation with passive net losses and recharacterization of self-rental property, feel free to email me to find out more about our consulting services.