Tax Court keeps taxpayer mistake from triggering the “self-rental” passive income rule.

November 14th, 2012 by Joe Kristan

Cell tower image courtesy Wikpedia Commons

The tax law “passive activity” rules were written to shut down real estate shelters by making rental losses “passive,” deductible only to the extent of “passive” income.  About 3 seconds after the rules were enacted, taxpayers began thinking of ways to generate passive income so they could deduct their passive losses by renting land or by renting property to a controlled business activity.  Rules treating “land rent” or “self-rental” net income as non-passive were issued quickly to stop that.

The new Obamacare 3.8% tax on “investment income” will apply to “passive income” as determined under the passive loss rules, so a  Tax Court decision issued yesterday exploring these issues takes on added importance.

The taxpayer leased land with cell-phone towers to his wholly-owned S corporation.  The S corporation in turn leased the towers to phone companies.  The taxpayer also leased land to his S corporation.

The S corporation mistakenly reported the income from its leases to the phone companies as ordinary income, rather than rental income, lumping the tower rental with the S corporation’s other business income.  The taxpayer treated the income as non-passive.

The towers leased to the S corporation were reported as passive leases on the taxpayer’s 1040, as were the land rents.  Some tower leases were profitable while others generated losses, but because they were all reported as “passive,” the losses and income offset.

The IRS had other ideas. The IRS left the K-1 income as non-passive, saying that the leases to the phone company wasn’t really “rental,” and in any case the taxpayer was stuck with the way the income was reported.  The IRS split the income from “self-rental” of the towers to the controlled corporation,  with the losses treated as passive and the income reclassified as non-passive under the self-rental rules.   The bottom line: a lot of non-passive income that couldn’t be offset by the now non-deductible passive losses.

The Tax Court said the IRS was being too cute.  The IRS said that the taxpayer was bound by his treatment of the S corporation tower income as non-passive because he had already grouped it with his other activities.   Judge Halpern said the IRS regulations didn’t have to cause such a harsh result.  While the taxpayer might be stuck with its return reporting for determining whether to report income from the K-1 as passive, that didn’t extend to the self-rental rules. so the taxpayer didn’t have to split up the cell-tower rental to the S corporation between profitable (non-passive) and loss-generating (passive):

We recognize that, because ICE erroneously reported all of its income as ordinary business (non-passive-activity) income, nonapplication of the self-rental rule of section 1.469-2(f)(6), Income Tax Regs., to ICE’s rental payments to petitioner, in effect, results in the reduction of what was reported as “active business income” and the offsetting creation of “passive income” in seeming contravention of the congressional conferees’ directive to issue regulations preventing that result. See H.R. Conf. Rept. No. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. We do not believe, however, that ICE’s tax return mischaracterization of its tower access rental income from third parties should control the application of the self-rental rule where, as here, it is, by its terms, inapplicable, i.e., where petitioner’s towers were not, in fact, used in a trade or business. Moreover, we are not persuaded that the result we reach herein violates the conferees’ directive as it does not, in fact, permit “passive income” to offset “active business income”.

The Tax Court upheld the IRS in treating the land-rental as non-passive.

The Moral?  The Tax Court reached a fair result, even though it had to stretch around the regulations to do so.  Had the towers been rented to the S corporation for use in its non-passive business, the judge would probably have given the IRS its “heads I win, tails you lose” treatment — the income would have been non-passive, and the losses would have been passive and non-deductible.  The result was different because the S corporation in turn leased the properties to third parties, instead of using them in its non-passive business.

The result is fair because the taxpayer isn’t really generating improper passive income that wouldn’t be there if it had reported the income on the K-1 properly in the first place.

This case reminds us how important it is to identify your passive activities and group them properly.   With the 3.8% tax on passive income taking effect in January, this is even more important.

Cite: Dirico, 139 T.C. No. 16.


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