PASSIVE ACTIVITY LOSS LIMITATIONS

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2 Hour(s) - Other Federal Tax

NASBA: 116347

CTEC Provider #: 6209CTEC Course #: 6209-CE-0009

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00202-21-S

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 7

Course Description ....................................................................................................................................................................... 7

Learning Objectives ...................................................................................................................................................................... 7

PASSIVE ACTIVITY LOSS LIMITATIONS............................................................................................................................... 7

General Limitations on the Use of Passive Losses ................................................................................................................... 7

Definition of a Passive Activity .................................................................................................................................................... 7

The Self-Rental Rules..................................................................................................................................................................11

GROUPING ACTIVITIES ...................................................................................................................................................... 12

Introduction.................................................................................................................................................................................12

The Basics of Grouping ..............................................................................................................................................................12

Limitations on Grouping ............................................................................................................................................................13

USE OF SUSPENDED PASSIVE LOSSES............................................................................................................................... 15

Qualifying Dispositions ..............................................................................................................................................................15

Grouped Activities.......................................................................................................................................................................16

Special Rules in Connection with Code Section 1411.............................................................................................................16

TREATMENT OF LIMITED PARTNERS................................................................................................................................ 16

Introduction.................................................................................................................................................................................16

Definition of Limited Partner.....................................................................................................................................................16

Limited Liability Company Members as Limited Partners.....................................................................................................17

RENTAL ACTIVITIES............................................................................................................................................................ 18

General Treatment of Rental Activities ....................................................................................................................................18

Exceptions to Passive Treatment of Rental Activity................................................................................................................18

The Net Investment Income Tax (NIIT).....................................................................................................................................25

GLOSSARY .......................................................................................................................................................................... 27

Glossary .......................................................................................................................................................................................27

Course Description 7

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COURSE OVERVIEW

COURSE DESCRIPTIONA common mistake made in tax preparation is the deduction of losses from passive activities without regard to the limits applicable to those losses. While rental real estate activities often generate passive losses, the passive loss limitation rules apply to a broad range of activities and are of particular concern to S corporation shareholders, partners, and members of limited liability companies. Furthermore, until further guidance is issued, the rules may be particularly tricky to apply with respect to LLC membership interests. The objectives of this course are to provide the practitioner with a sound understanding of the basic rules related to passive activity loss limitations and their application in common scenarios. The course covers the relevant definitions and exceptions regarding passive loss limitations with which every tax practitioner should be familiar.

LEARNING OBJECTIVESUpon completion you will be able to:

Identify passive activities

Calculate hours spent in order to determine classification of participation in an activity

Recognize applicability of grouping activities

Name the tests associated with determination of material participation

PASSIVE ACTIVITY LOSS LIMITATIONS

GENERAL LIMITATIONS ON THE USE OF PASSIVE LOSSESTwo emerging perceptions gave rise to the enactment of the passive loss limitation rules contained in Internal Revenue Code (“Code”) section 469 in 1986. The public had become increasingly suspicious of the tax system, a feeling that culminated in the wholesale revision of the Code in that year. Secondly, the rise of tax shelters had contributed to the belief that federal income tax was paid only by the naive and unsophisticated who were unwilling or unable to “to offset income from one source with tax shelter deductions and credits from another.”

As part of its effort to curtail the use of tax shelters, Congress decided to limit the deductibility of so-called “passive activity” losses. Specifically, Code section 469 provides that passive activity losses are deductible only to the extent of passive activity income received or accrued within the current taxable year. Losses disallowed under this provision may be carried forward indefinitely to subsequent years. For example, a taxpayer who has a $10,000 gain from a passive activity and a $12,000 loss from another passive activity is confronted with a $2,000 passive activity loss, which is disallowed as a deduction for the taxable year but may be carried forward.

DEFINITION OF A PASSIVE ACTIVITYA passive activity is defined as “any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.” The term “trade or business” encompasses activities that would normally be considered business operations (i.e., activities that give rise to ordinary and necessary business expenses), as well as activities conducted in preparation for the commencement of such operations. It also includes activities that involve research or experimental expenditures deductible under Code section 174.

“Trade or business” does not include rental activities. However, rental activities, regardless of the taxpayer’s material participation, are considered passive activities. A rental activity is defined as any arrangement in which tangible property (real or personal) is used by others in exchange for payments made to the owner for the use of the property.

Note that “use” payments for intangible property (such as patents or trademarks) are considered royalties and therefore generally fall under the category of non-passive portfolio income.

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8 Passive Activity Loss Limitations

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Thus, passive activities fall into two general categories: trades or businesses in which the taxpayer does not materially participate and rental activities. It does not matter if the passive activity is held directly by the taxpayer or indirectly through pass-through entities. For example, a joint venture conducted by a partnership will generally be considered a passive activity with respect to each of the partners.

Not only is the income or loss generated by the conduct of the passive activity considered passive, any gain or loss realized upon the disposition of a passive activity is also treated as passive. Next we will consider how to determine if a particular activity is passive or not as to a particular taxpayer.

SOURCES OF INCOME AND EXPENSE THAT ARE AUTOMATICALLY CONSIDERED NON-PASSIVE

Portfolio Income

The Code provides certain exclusions that result in non-passive treatment for what might otherwise be considered passive activities. Specifically, “portfolio income” is not to be treated as derived from a passive activity, despite the seemingly passive nature of investing activities. Portfolio income includes all gross income that is attributable to:

interest,

dividends,

annuities, or

royalties;

Likewise, any expenses which are clearly and directly allocable to such gross income do not give rise to passive activity deductions, nor do any interest expenses properly allocable to that income. For example, assume a taxpayer owns an interest in an S corporation in which the taxpayer does not materially participate. The S corporation borrows money to buy equipment used in its operations and to finance the purchase of stocks. The interest paid by the S corporation must be allocated between the equipment and the stocks. The taxpayer in this case takes into account only the interest expense related to the equipment purchase in determining his income or loss from passive activities. The interest expense related to the stocks is allocated to the taxpayer’s portfolio income and is not treated as passive.

An expense is clearly and directly allocable to portfolio income if it's incurred in connection either with an activity in which portfolio income is derived or with property from which portfolio income is derived. For example, administrative expenses attributable to the performance of services that do not directly benefit a particular investment activity that generates portfolio income would not be clearly and directly allocable to that portfolio income.

Also included in portfolio income (and hence excluded from passive income) is any gain or loss attributable to the disposition of property producing income of a type described above. For example, suppose a taxpayer is a partnership operating a rental apartment building for low-income tenants. Assume that under applicable local law, the partnership is required to maintain a reserve fund to pay for maintenance and repair of the building, pursuant to which the taxpayer invests the reserve fund in short-term interest-bearing deposits. The interest income is not derived in the ordinary course of a trade or business and therefore is considered portfolio income.

Compensation for Services

Passive activity gross income does not include compensation for personal services paid to (or for the benefit of) an individual for personal services performed or to be performed by that individual. For this purpose “compensation for personal services” is expansively interpreted and includes not only earned income, but also amounts paid under a retirement, pension, or other deferred compensation agreement, as well as social security benefits. It does not, however, include portion of a partner's distributive share of partnership income or a shareholder's pro rata share of income from an S corporation.

For example, assume a taxpayer owns 50% of the stock of an S corporation and that the S corporation owns and manages rental real estate. The S corporation pays the taxpayer a salary for services performed on behalf of the corporation in connection with the property rental management. Under these circumstances the taxpayer’s

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Definition of a Passive Activity 9

proportionate share of the corporation’s gross rental income is passive activity gross income, but the taxpayer’s salary does not constitute passive activity gross income.

Payments Related to a Retiring Partner

Generally, when a taxpayer disposes of his or her entire interest in any passive activity, gain or loss on the disposition is recognized, and the excess of net losses over net income is treated as a loss that is not from a passive activity. This rule applies to a retiring partner’s distributive share of suspended passive losses.

Note, however, that a partner is only considered to have “retired” for the purposes of subchapter K when his or her interest in the partnership has been completely liquidated. Thus, a retiring partner who receives installment or contingent payments is treated as a partner until his or her entire interest is liquidated.

For example, assume A is a passive investor in XYZ partnership. A’s partnership interest is redeemed over a period of three years for three annual payments of $30,000. If the redemption results in a loss, the loss is considered passive until the final installment, at which time the loss will be treated as not generated by a passive activity because A’s partnership interest has been entirely liquidated.

THE TRADE OR BUSINESS REQUIREMENT

As noted above, a passive activity generally involves the conduct of a trade or business. “Trade or business” activities are activities (other than rental activities or activities that are incidental to the holding property for investment) that are: (1) conducted in connection with a trade or business in which deductions are permitted under Code section 162, (2) conducted in anticipation of the commencement of a trade or business, or (3) involve research or experimental expenditures deductible under Code section 174.

For a taxpayer’s activity to be treated as a trade or business, the primary purpose for engaging in the activity must be for generating profit. An activity that falls under the restriction of the Code section 183 “hobby loss” rules is not considered a trade or business. An actual profit does not have to be obtained, but the taxpayer must have a good faith intention of making a profit. Whether an activity is carried on with the good faith intention of making a profit or as a hobby for recreation and pleasure is determined by all of the facts and circumstances.

THE MATERIAL PARTICIPATION TESTS

General rule

“Participation" means any work done in an activity by an individual who owns an interest in the activity. “Material” participation means that the taxpayer is involved in the operations of the activity on a basis which is “regular, continuous, and substantial.” In order for a taxpayer’s participation to be considered “regular, continuous, and substantial” the taxpayer must meet any one of seven different tests. Each of those tests is described below.

More Than 500 Hours of Participation

A taxpayer materially participates in an activity if he or she participates more than 500 hours during the taxable year in a trade or business.   A taxpayer may establish participation in an activity by any reasonable means. For example, a corporation may achieve the requisite participation through the active participation of shareholders who hold a majority of the corporation’s stock.

Assume a taxpayer owns all of the stock of a C corporation. The taxpayer and the corporation form a partnership in which the corporation is the general partner and the taxpayer is the limited partner. The partnership has a restaurant trade or business activity. During the taxable year, the taxpayer works for an average of 30 hours per week in connection with the restaurant activity. Under these circumstances the taxpayer is treated as materially participating in the restaurant activity because he participates for more than 500 hours during the year. Furthermore, the taxpayer’s participation will also cause the corporation to be treated as materially participating in the restaurant activity.

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Note that “reasonable means” is interpreted broadly, but there are limits. For example, a post-event “ballpark guesstimate” will not be sufficient. In the example above, if the taxpayer had no evidence to support the specific level of participation claimed, the activity may be recharacterized as passive for both the taxpayer and the corporation.

Substantially All Participation Is by the Taxpayer

A taxpayer materially participates in an activity if he or she performs substantially all of the work associated with that activity, whether or not as an employee, without regard as to the specific number of hours worked.

In assessing whether this test has been met, the IRS and the courts will focus on whether any substantial tasks with respect to an activity are the responsibility of persons other than the taxpayer. In one case, for example, the Tax Court found that the taxpayer did not materially participate in the rental of residential real property because mowing and repairs were done by tenants, the homeowners association, or hired help. In another case the court held that taxpayer failed to meet the “substantially all participation” test in his real estate rental activity because the residential leases provided that the tenants themselves were responsible for property maintenance and because taxpayer only visited the property once during the taxable year.

Practice Tip: Make sure your client’s activities are documented and the level of participation asserted makes sense from a practical standpoint. A taxpayer who asserts that he or she performs substantially all of the services with respect to an activity but resides a substantial distance from that activity will need to document both the required tasks associated with the activity and the fact that they physically completed those tasks.

More Than 100 Hours of Participation

A taxpayer materially participates in an activity if he or she participates for more than 100 hours during the taxable year, and such participation in the activity for the taxable year is more than the participation any other person, including those who are not owners of interests in the activity.

For example, suppose a taxpayer is a full-time carpenter that has an interest in a partnership engaged in a van conversion activity conducted entirely on Saturdays. Each Saturday throughout the year, the taxpayer and a partner each work for eight hours in the activity. Assuming there is no other activity by the partner, the taxpayer would be treated as materially participating in the activity because he participates for more than 100 hours during the year and his participation is not less than the participation of any other person in the activity for such year.

Significant Participation Activities

A taxpayer materially participates in an activity if the activity is a so-called “significant participation activity” for the taxable year, and his or her aggregate participation in all significant participation activities during such year exceeds 500 hours. The term “significant participation activity” refers to a trade or business in which the taxpayer’s participation aggregates more than 100 hours during the year but as to which the taxpayer does not meet any other material participation test.

Suppose a taxpayer is employed full-time as an accountant but also owns interests in a restaurant and a shoe store, each of which are treated as separate activities. Assume the taxpayer worked in the restaurant for 400 hours and in the shoe store for 150 hours. Under these circumstances each activity would be considered a significant participation activity and, since the aggregate time devoted to the activities exceeds 500 hours, the taxpayer is considered to have materially participated in both.

Note that, had the taxpayer worked in the restaurant for more than 500 hours, the restaurant activity would not be a significant participation activity because it would meet another material participation test. In that case the shoe store activity would not meet the significant participation test because it could not be aggregated with the restaurant activity.

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The Self-Rental Rules 11

Material Participation in Five of the Last Ten Taxable Years

A taxpayer materially participates in an activity if he or she materially participated in the activity for any five taxable years, whether or not consecutive, during the immediately preceding ten taxable years.

This test most commonly applies after a taxpayer has ceased to materially participate in a business but continues to maintain an ownership interest. For example, suppose a taxpayer acquires stock in an S corporation engaged in a trade or business activity and materially participates in the business from 2015 through 2019. In 2019 the taxpayer retires but keeps his S corporation stock. The taxpayer will be treated as materially participating in the business activity each year through 2025 because he materially participated in the activity for five years of the ten immediately preceding tax years. On the other hand, beginning in 2026 the taxpayer would not be treated as materially participating in the activity.

Material Participation in a Personal Service Activity for Three Prior Years

A taxpayer materially participates in an activity if the activity is a “personal service activity” in which he or she materially participated for any three prior taxable years, whether or not consecutive. A “personal service activity” is an activity that “involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or any other trade or business in which capital is not a material income-producing factor.” Thus a retired partner in a law firm that continues to own a partnership interest and receives distributions will be treated as materially participating in the firm as long as he or she holds the partnership interest, assuming retired lawyer materially participated in the firm for at least three years before his or her retirement.

Facts and Circumstances Test

A taxpayer who fails to meet any one of the preceding tests nonetheless materially participates in an activity if the facts and circumstances demonstrate that he or she materially participated in that activity during the taxable year.For this test to apply the taxpayer must participate in the activity for a minimum of 100 hours.

Cases in which the facts and circumstances test was successfully utilized by taxpayers include a case involving a taxpayer who acted as a construction coordinator for movie sets. In that case the Tax Court found that the taxpayer’s hiring of other employees, arranging for the purchase of materials, and the furnishing of tools and equipment constituted regular, continuous, and substantial participation. In another case the taxpayer personally purchased equipment for a leasing activity, maintained business expense records, and conducted transactions relating to the activity to a sufficient degree to conclude that his participation was material under the facts and circumstances test.

THE SELF-RENTAL RULESThe regulations at section 1.469-2T(f) recharacterize passive income in certain situations. This so-called “self-rental rule” prevents taxpayers from converting non-passive income to passive income from an active business in which tangible property is used by renting the property to an entity conducting the activity, or by causing the entity holding the property to rent it to the taxpayer. A taxpayer might do this, for example, to generate sufficient passive income to absorb passive losses from other activities.

Suppose Joe runs an accounting practice that he materially participates in and has passive activity losses from other sources. In order to take immediate advantage of the passive activity losses, Joe decides to rent office equipment to the accounting practice to generate passive income.

Note the self-rental rule recharacterizes the rental income from an item of property, rather than from an activity. This can result in a sort of “double whammy” for taxpayers. Suppose a taxpayer owns Property A, which he or she rents at a profit to S corporation X, and the taxpayer also owns Property B, which they rent at a loss to S corporation Y. Assume the taxpayer materially participates in both corporations. The rental income from Property A would be recharacterized as nonpassive under the self-rental rule, even though taxpayer properly treated the rentals of both properties as a

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12 Grouping Activities

single activity. The self-rental rule would apply to the income from the rental of Property A as an item of property, not to the net income from the grouped Property A and Property B rental activity. As a result, the income from the rental of Property A (recharacterized as nonpassive) could not be used to absorb the loss from Property B, which had to be treated as passive under the rule generally treating rental activities as passive activities.

Similarly, where the taxpayer materially participated in his trucking business that leased its trucking equipment from two separate taxpayer-owned leasing companies, each tractor or trailer was a “single item of property.” The Tax Court upheld IRS's determination that one company's net income for the year at issue, which the taxpayer had treated as passive, should be recharacterized as nonpassive under the self-rental rule and so couldn't be offset by the other company's net loss for the year. The taxpayer had contended that within the trucking industry, “item of property” typically refers to an entire fleet of trucks; this meant that the net income and the net loss came from a single business, and were both passive. The Tax Court found that argument implausible, as well as inconsistent with the facts of the case. Both companies owned only the tractors and trailers that each leased to the taxpayer's trucking business. During the year at issue, they entered into approximately 200 separate lease agreements with that business, leasing each tractor or trailer as one unit at an independently determined monthly rate.

GROUPING ACTIVITIES

INTRODUCTIONFor the purpose of applying the passive loss limitation rules of Code section 469, taxpayers are permitted to group together activities that constitute “appropriate economic units” in light of all the relevant facts and circumstances.Which activities are grouped together, of course, will impact the tax consequences for the taxpayer, so practitioners must be familiar with the grouping rules.

THE BASICS OF GROUPINGFor purposes of applying the passive activity loss limitation rules, taxpayers are allowed to group activities constituting an “appropriate economic unit.” A decision by a taxpayer to group activities is generally irrevocable; once a taxpayer groups two or more activities he or she may not re-group those activities in a later tax year. On the other hand, if the original grouping is clearly inappropriate, or there is a material change in the facts and circumstances that makes the original grouping clearly inappropriate, the taxpayer is required to un-group the activities.

DISCLOSURE REQUIREMENTS

To take advantage of grouping, a taxpayer must attach certain disclosures to their tax returns. Taxpayers (other than pass-through entities) must a file a written statement with their original income tax return for the first taxable year in which there is a new grouping, an addition to an existing grouping, or a re-grouping where the original grouping was clearly inappropriate or a material change in circumstance has occurred that makes the original grouping clearly inappropriate.

The written statement must identify the names, addresses, and employer identification numbers for each of the activities involved and must contain a declaration that “the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.”

Partnerships and S corporations are required to comply with the disclosure instructions for grouping activities provided with Form 1065 or Form 1120S. If a pass-through entity groups its activities, the partners or shareholders are not required to file a separate disclosure statement with their own returns unless they group together any activities that the entity did not group together, group their own activities with the entity’s activities, or group activities of different entities with each other. Once grouped at the entity level, however, partners or S corporation shareholders may not treat such activities as separate activities.

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Limitations on Grouping 13

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APPROPRIATENESS OF GROUPING

Whether a particular grouping of activities constitutes an appropriate economic unit is determined on a facts and circumstance basis. In addressing this issue, the following factors must be analyzed:

similarities and differences in types of trades or businesses;

the extent of common control;

the extent of common ownership; and

the relative geographical proximity of the businesses.

Interdependencies between or among the activities may also be considered. For example, it may be appropriate to group activities dealing with products or services normally provided together, or those that have the same customers, employ same individuals, or are accounted for with a single set of books and records.

For example, suppose a taxpayer possesses significant ownership interest in two bakeries and two movie theaters, one of each in Baltimore and one of each in Philadelphia. Under these facts there may be several reasonable methods for grouping the activities. For example there may be a grouping into two activities (a movie theater activity and a bakery activity or a Baltimore activity and a Philadelphia activity). On the other hand, the facts could support one single activity, or four separate activities.

While facts like these may allow for multiple grouping approaches, taxpayers cannot simply group activities any way they see fit. The Code itself places limits on the grouping of certain activities.

LIMITATIONS ON GROUPINGGROUPING TRADE OR BUSINESS ACTIVITIES WITH RENTAL ACTIVITIES

A rental activity may not be grouped with a trade or business activity unless the grouping constitutes an appropriate economic unit and: (1) the rental activity is insubstantial compared to the trade or business activity; (2) the trade or business activity is insubstantial compared to the rental activity; or (3) each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items for use in the trade or business activity may be grouped with the trade or business activity.

Under the “basic undertaking rule,” the determination of whether business and rental activities constitute a single undertaking is made by reference to their location and ownership. This means that business or rental activities conducted at the same location and owned by the same person are generally treated as part of the same undertaking.

For example, assume H and W file a joint return. H is the sole shareholder of an S corporation that operates a grocery store and W is the sole shareholder of an S corporation that owns and rents out a building that contains H’s grocery store. Because H and W file a joint return they are treated as one taxpayer. Consequently, each has the same proportionate ownership interest in the other’s activity. Therefore, the grocery store trade or business and the rental trade or business may be grouped together into a single trade or business activity.

Location, however, is disregarded where place of operation does not depend on any fixed place for operation of the business and rental activities. In addition, operations that are conducted at a location but do not relate to the production of property at that location or to the transaction of business with customers at that location are treated, in effect, as part of the undertaking or undertakings that the operations support.

GROUPING REAL PROPERTY AND PERSONAL PROPERTY RENTALS

The rental of real property and the rental of personal property generally may not be grouped as a single activity.However, a taxpayer may group the rental of real property with the rental of personal property to the extent that (i)

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personal property is provided in connection with real property, or (ii) real property is provided in connection with personal property.

LIMITED PARTNERS AND LIMITED ENTREPRENEURS

A special rule applies to limited partners and so-called “limited entrepreneurs.” The term “limited entrepreneur" means a person who has an interest in an enterprise other than as a limited partner but does not actively participate in the management of the activity. A taxpayer who has an interest in an activity as either a limited partner or a limited entrepreneur may only group that activity with another activity that is in the same line of business.

For example, suppose an individual taxpayer owns and operates a farm and also owns an interest in a limited liability company that conducts a cattle-feeding business, but does not actively participate in the management of the LLC. Assume the taxpayer is also a limited partner in a business engaged in oil and gas production. Because taxpayer does not actively participate in the management of the cattle-feeding business, he is considered a limited entrepreneur as to that activity and can only group it with other activities in the same line of business. Since the cattle-feeding business is in the same line of business as the farm, those two activities may be grouped, assuming they form an appropriate economic unit. The oil and gas activity, however, may not be grouped with either of the other two, since the taxpayer is a limited partner in that activity and it is in a separate line of business.

GROUPING AT THE ENTITY LEVEL

The ability to use grouping is not limited to individual taxpayers. A corporation subject to taxation under either Subchapter C or Subchapter S, as well as a partnership or limited liability company that is subject to the passive loss rules may group its activities for this purpose.

Note that for pass-through entities, grouping decisions are made at the entity level, not at the partner or shareholder level. However, once a partnership, limited liability company, or S corporation groups its activities, an owner of the pass-through entity may further group those activities with each other, with his or her own activities, or with activities conducted through other entities. Such owners may not, however, “un-group” the activities grouped at the entity level; in other words, a pass-through entity owner may not treat activities grouped together by the entity as separate activities.

Practice Tip: In circumstances where a partnership, limited liability company, or S corporation plans to engage in multiple activities that could be subject to grouping, the owners may want to specify any requirements or restrictions on grouping at the entity level by adding appropriate provisions to the partnership or shareholders’ agreement.

SPECIFIC ACTIVITIES IDENTIFIED BY THE COMMISSIONER

In addition to the grouping restrictions described above, Congress has authorized the IRS to prohibit any such groupings as it sees fit to restrict, even without the adoption of further regulations. For instance, in connection with a partnership allocation safe harbor rule related to “wind farm” partnerships between project developers and one or more participating investors, the IRS announced that a qualified wind energy facility can only be grouped with other qualified wind energy facilities.

This presents a real challenge for taxpayers and their advisors. Not only do practitioners have to be careful not to transgress the general rules with regard to grouping, they must be aware that there may be specific prohibitions identified in various rulings issued by the IRS.

Practice Tip: The IRS is most likely to provide special grouping rules related to activities that generate special deductions and credits, such as the renewable energy credit described in the example above. Therefore, before grouping any activity that generates special deductions or credits, the careful practitioner will perform a search for revenue procedures that may restrict the grouping options.

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Qualifying Dispositions 15

IRS AUTHORITY TO GROUP IN ORDER TO PREVENT TAX AVOIDANCE

In addition to providing guidance regarding specific activities, the IRS may regroup any activity if it determines: (1) that the taxpayer's grouping does not constitute an appropriate economic unit and (2) a principal purpose of the taxpayer's grouping is to circumvent the underlying purposes of the statute. For example, suppose a physician invests in real estate that creates passive losses. That physician and others who hold similar investments get together to form a partnership to acquire and operate X-ray equipment. Each physician is a limited partner in the X-ray activity and that activity primarily provides services to each of the physicians’ practices. Because the limited partner physicians pay for those services in roughly the same amount they would pay an unrelated X-ray provider, the partnership generates income, which the physicians treat as passive income from a separate activity against which they offset their passive losses from the real estate investments.

Under these facts the IRS may conclude that a primary purpose of treating the medical practices and the partnership's services as separate activities is to circumvent the passive loss limitation rules and require that each of the physicians group their medical practices with their respective interests in the partnership. While each doctor’s own medical practice may constitute an appropriate economic unit, the partnership’s services do not appear to be sufficiently distinct from those practices to constitute a separate economic unit.

USE OF SUSPENDED PASSIVE LOSSES

QUALIFYING DISPOSITIONSAs noted above, disallowed passive activity losses are “suspended” and may be carried forward indefinitely and used to offset passive income in future years. The purpose of this suspension is to prevent the taxpayer from benefiting from a net loss from passive activities until such time as the taxpayer relinquishes all economic interest in the activity.

When a qualifying disposition of the passive activity that generated the losses occurs, however, the suspended losses become fully deductible. A “qualifying disposition” is defined as a transfer that disposes of the taxpayer’s entire interest in the passive activity to an unrelated party in a fully taxable event. As a result, transfers that are not taxable events (such as a transfer of property to a partnership for a partnership interest or the contribution of property to a controlled corporation in exchange for stock) will not give rise to the realization of suspended losses. This is because in such transfers the taxpayer is not entirely extricating himself or herself from the activity.

When a qualifying disposition does take place, any loss from the activity for the year of the disposition that exceeds any net income or gain for that year from all other passive activities is considered a non-passive loss. Any gain from disposition of the activity is offset first by any loss from the activity for the tax year of the disposition and then by any suspended losses from the activity. The remaining suspended losses, if any, are applied first against any net income or gain from other passive activities, and finally against non-passive income.

If the gain from the sale is recognized on the installment sale basis, only a proportionate share of the suspended loss (corresponding to the percentage of the gain recognized in any taxable year) is deductible. Furthermore, when a taxpayer disposes of a passive activity that has suspended losses that exceed the gain on disposition, the net passive income and net passive losses from all of the taxpayer's other passive activities must be netted before any excess passive income is applied against the suspended passive losses from the disposed of activities. Only the remaining excess losses from the disposed of activity are treated as losses not from a passive activity.

Suppose, for example, a taxpayer disposed of his interests in a passive activity and that the transaction resulted in $25,000 of gain. Assume further that the activity had a total of $100,000 of suspended passive losses. In the same year, the taxpayer had $30,000 of net passive income from a second activity and $10,000 of net passive loss from a third activity, both of which the taxpayer is retaining. The taxpayer must first offset the $25,000 gain from the disposed of activity with the suspended losses. The taxpayer then nets his income and losses from the two additional activities

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($30,000 – $10,000), and subtracts the resulting net passive income ($20,000) from the $75,000 of remaining suspended losses. Thus only $55,000 of suspended losses is treated as losses not from a passive activity.

GROUPED ACTIVITIESAs indicated above, an entire activity must be disposed of before the suspended losses may be utilized by the taxpayer. This rule is consistent with the intent of Congress to inhibit the use of tax shelters that create current passive losses that will be offset by later gains; since the activity is being disposed of, there is no longer any danger of this abuse.

With respect to grouped activities, this may work as a disadvantage to taxpayers, and practitioners should be careful to advise their clients of the potential pitfall of grouping. Suppose, for example, that a taxpayer has suspended losses from activity A and then decides to group activity A with activity B. The suspended losses will not be available if the taxpayer later disposes of activity A only, as the grouping has rendered activity A and activity B part of a single activity for the passive loss rules, requiring disposition of the entire activity before the suspended losses are released.

Although it is true that a taxpayer may make a so-called “partial disposition election,” this technique only applies in the case of a disposition of “substantially all” of an activity. Furthermore, the taxpayer must be able to establish with reasonable certainty (i) the amount of deductions and credits allocable to that disposed part of the activity for the taxable year and (ii) the amount of gross income and other deductions and credits allocable to that disposed part of the activity for the taxable year.

SPECIAL RULES IN CONNECTION WITH CODE SECTION 1411In general, once a taxpayer has grouped activities for purposes of the passive activity loss rules he taxpayer is prohibited from re-grouping those activities in later tax years. Beginning is 2013, Code section 1411 imposes a net investment tax of 3.8% on individuals, trusts, and estates with “net investment income” above certain statutory amounts (see discussion below). Because the net investment income tax may cause taxpayers to reconsider their previous grouping determinations, the IRS is providing taxpayers with an opportunity to redetermine their groupings on a one-time basis.

Under this rule, an individual, trust, or estate may re-group its activities, regardless of how they were grouped in the preceding tax year in the first tax year beginning after December 31, 2013 in which the net investment income tax would apply to the taxpayer. Note that a taxpayer may re-group activities only once under this rule, and the re-grouping will apply for the tax year for which it is done and all later tax years.

TREATMENT OF LIMITED PARTNERS

INTRODUCTIONThe Code provides that, generally, a limited partner is not treated as materially participating in any activity of the limited partnership with respect to his or her share of the income, gain, loss, deduction, or credit from the activity attributable to the limited partnership interest. Furthermore, any gain or loss from the disposition of the limited partner’s limited partnership interest is likewise treated as passive. A limited partner may prove his material participation but is restricted in proof to only three of the seven material participation tests: more than 500 hours of participation, material participation in five of the last ten taxable years, and material participation in a personal service activity for three prior years.

DEFINITION OF LIMITED PARTNERThe term “limited partner” is not defined in the Code. For purposes of the application of self-employment taxes, the current proposed regulations define a limited partner as someone who (1) lacks personal liability for debts of or claims

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against the partnership by reason of being a partner; (2) lacks authority to contract on behalf of the partnership; or (3) does not participate in the partnership's trade or business for more than 500 hours during the taxable year.

“Limited partnership interest” means “such interest is designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership” whether or not the interest holder’s liability for partnership obligations is limited under applicable state law.” It also encompasses situations in which the interest holder’s liability for partnership obligations is limited under the state law in which the partnership is organized, “to a determinable fixed amount (for example, the sum of the holder's capital contributions to the partnership and contractual obligations to make additional capital contributions to the partnership).”

Thus a partnership interest is treated as a limited partnership interest if the interest is actually designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership or the liability of the holder of the interest for the partnership’s obligations is limited under the law of the state where the partnership is organized to a fixed amount, such as his or her capital contributions. On the other hand, a partnership interest is not treated as a limited partnership interest if the individual is also a general partner as well as a limited partner in the same partnership.

Unfortunately, none of these definitions specifically address the status of a member of a limited liability company. As a result, the IRS, the courts, and taxpayers are forced to grapple with whether or not a limited liability company member is equivalent to a limited partner for purposes of applying the passive activity loss rules. As you might imagine, they have done so, with somewhat surprisingly taxpayer-friendly results.

LIMITED LIABILITY COMPANY MEMBERS AS LIMITED PARTNERSIn Garnett v. Commissioner, the taxpayer owned interests in several limited liability companies and used the losses generated by those activities to offset other income without regard to the passive activity loss limitation rules. The IRS disallowed some of the losses, claiming that taxpayer’s LLC membership interests were interests held as a “limited partner” and consequently those activities must be treated as presumptively passive.

The Tax Court disagreed and determined that, absent an express statutory provision to the contrary, a limited liability company member is not automatically considered a limited partner for purposes of the passive activity loss rules. The court noted that interests in LLCs are fundamentally different from limited partnership interests because they allow for participation in management. As such, the court held that an LLC membership interest should be analyzed under a facts and circumstances test to determine the nature and extent of the taxpayer's participation in the entity's business, applying the general material participation tests.

Unfortunately, the result in the Garnett case did not persuade the IRS. In Thompson v. United States, the taxpayer formed a limited liability company which, as in Garnett, generated losses. In this case the taxpayer used those losses to claim refunds. The IRS denied the refund claim, maintaining once again that taxpayer was a “limited partner.” The IRS posited that an LLC member is substantially equivalent to a limited partner in that the LLC member enjoys limited liability protection and partnership taxation.

The Thompson case was decided by the Court of Federal Claims which, like the Tax Court before it, disagreed with the reasoning of the IRS. The court pointed out that Code section 469(h)(2) plainly and unambiguously applies only to entities formed as a “limited partnerships,” and that a limited liability company is not substantially equivalent to a limited partnership due to the fact that LLC members may materially participate in the business.

The IRS decided to acquiesce in the Thompson result only, refusing to accept the position that Code section 469(h)(2) applied solely to limited partnerships or that limited liability company membership interests are not the equivalent of a limited partner’s interest in a limited partnership for purposes of the passive loss limitation rules.

The IRS has remained steadfast in its belief that limited liability company members should be treated as limited partners for passive loss limitation purposes. In Newell v. Commissioner the taxpayer was a Florida attorney primarily engaged in real estate investments as a managing member in a California LLC. The IRS again argued that the

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taxpayer’s LLC interest was substantially equivalent to an interest held by a limited partner. The case eventually found its way to the Tax Court, which reiterated its position in Garnett and held that Code section 469(h)(2) plainly requires that the subject ownership interest be held in limited partnership rather than in an LLC.

Despite the IRS position that limited liability company members should be considered the equivalent of limited partners for passive activity purposes, the courts have clearly and consistently disagreed. As a result, unless and until further authoritative guidance is promulgated, taxpayers are faced with the prospect of having to litigate this issue.

Practice Tip: Each of the cases cited above deals specifically with the application of the passive activity loss rules and does not address the related issue of the self-employment tax. Since the IRS has taken the position that limited liability company members are limited partners, it follows that they should not be subject to self-employment tax other than with regard to guaranteed payments. Practitioners will therefore have to decide if they want to avoid self-employment tax at the expense of having the pass-through income or loss treated as passive.

RENTAL ACTIVITIES

GENERAL TREATMENT OF RENTAL ACTIVITIESRental activities are per se passive activities, whether or not the taxpayer materially participates in the activity.“Rental activities” are defined as activities in which real property or tangible personal property is used by non-owners and amounts are paid by such non-owners to the owner principally for the use of the property. Any rental real estate that the taxpayer has properly grouped with a trade or business activity, however, is not considered an interest in rental real estate for purposes of the passive activity loss rules.

EXCEPTIONS TO PASSIVE TREATMENT OF RENTAL ACTIVITYUSE PERIOD OF SEVEN DAYS OR LESS

An activity involving the use of tangible property is not a rental activity if the property was held for use by non-owners for an average of seven days or less. This exception most commonly applies in the case of vacation condominium rentals, hotel and motel rooms, and businesses that rent inventories such as videotapes, tuxedos, and automobiles.

AVERAGE CUSTOMER USE PERIOD OF 30 DAYS OR LESS

An activity involving the use of tangible property is not a rental activity if the property was held for use by non-owners for an average of 30 days or less and significant personal services are provided by or on behalf of the property owner.

Among the services that do not count as “significant personal services” are services necessary to permit the lawful use of the property and services in the form of improvements or repairs that extend the useful life of the property. Additionally, services that are similar to those commonly provided in connection with long-term rental of high-grade commercial or residential real property do not count. For example, maid service, cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security would not constitute significant personal services.

On the other hand, a taxpayer who maintained, transported, and repaired the tools and equipment that he rented to movie production companies was held to have provided significant personal services in connection with the rentals.

PROVIDING EXTRAORDINARY PERSONAL SERVICES

An activity involving the use of tangible property is not a rental activity if extraordinary personal services are provided by or on behalf of the property owner, without regard to the average period of customer use. The situations in which this exception applies are generally circumstances where use of the property is merely incidental to personal services provided. An example would be the personal services provided by a rehabilitation hospital’s medical and nursing staff during a patient’s stay in the facility.

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INCIDENTAL RENTAL ACTIVITIES

An activity involving the use of tangible property is not a rental activity if the property rental is treated as incidental to the non-rental activity of the taxpayer. This exception will apply with regard to property that is held for investment or used in a trade or business where the gross rental income from such property is less than two percent of the lesser of its adjusted basis and fair market value.

For example, suppose a taxpayer owns 1,000 acres of unimproved land with a fair market value of $350,000 and an unadjusted basis of $210,000. The land is held principally for realizing gain from appreciation. To defray the cost of carrying the land, the taxpayer leases the land to a rancher for $4,000 per year.

In this case, the gross rental income from the land is less than two percent of the lesser of the fair market value and the unadjusted basis of the land ($210,000 × 2% = $4,200). Accordingly, the rental of the land is not considered a “rental activity” for purposes of the passive loss rules because the rental is incidental to an activity of holding the property for investment.

PROPERTY CUSTOMARILY MADE AVAILABLE FOR NONEXCLUSIVE USE

An activity involving the use of tangible property is not a rental activity if the taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers. A common example would be a golf course. Since the owner makes the golf course available during prescribed hours for nonexclusive use by various customers, it is not considered a rental activity.

PROPERTY CONTRIBUTED TO A PASS-THROUGH ENTITY

An activity involving the use of tangible property is not a rental activity if the taxpayer contributes property for non-rental use to a partnership, S corporation, or joint venture in which he or she owns an interest.

RENTAL OF PRIMARY RESIDENCE

Renting residential property that the taxpayer used as a principle residence for more than 14 days during the tax year will generally not be considered a rental activity and is per se not passive. A residence will be treated as rented during any period that the taxpayer holds the residence out for rental, resale or repairs; or renovates the residence with the intention of holding it out for rental or resale.

THE ACTIVE PARTICIPATION EXCEPTION

In addition to the rules set forth above, a taxpayer may deduct up to $25,000 in rental real estate losses against non-passive income as long as he or she actively participates in the rental real estate activity. This exemption, however, is subject to a phase-out. The $25,000 amount is reduced, but not below zero, by 50% of the amount by which the taxpayer's annual adjusted gross income exceeds $100,000. For married taxpayers filing a separate return, only $12,500 is available to offset non-passive income, reduced by 50% of the amount by which the taxpayer’s annual adjusted gross income exceeds $50,000.

Active participation does not require regular, continuous, and substantial involvement in activities. Rather, it merely requires that the taxpayer participates in making management decisions in a significant and bona fide way.

Practice Tip: Use of a management company will usually derail any argument that the taxpayer actively participates. Therefore, if a taxpayer wants to tax advantage of this exception, a management company should be used only for ministerial functions (such as collecting rents) and all decision-making should be done by the taxpayer.

THE REAL ESTATE PROFESSIONAL EXCEPTION

Code Section 469(c)(7) provides an exception to the rule that a rental activity is per se passive. The rental activities of a taxpayer in a “real property trade or business” who meets certain designated requirements establishing their status as a “real estate professional” is not subject to the per se rule discussed above. Instead, the rental activities of a real

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estate professional are subject to the material participation requirements. "Real property trade or business" means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

A taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades and businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. Code section 469(c)(7)(D)(ii) generally precludes services performed by an employee who is not a 5% owner from being treated as performed in a real property trade or business. In the case of a joint return, these requirements are satisfied only if either spouse separately satisfies these requirements.

Remember that qualification as a real estate professional is only half the battle in a case where the taxpayer wants to treat rental activity as non-passive. Attaining the status of real estate professional does not mean that all of the taxpayer’s rental activities are non-passive, but only that rental activities in which he or she materially participates are non-passive. Being a real estate professional simply provides the taxpayer with the opportunity to avoid the passive activity rules by demonstrating material participation with respect to a rental activity, an opportunity that is not available to anyone who is not a real estate professional.

As always, the burden is on the taxpayer to prove an entitlement to a deduction. Take the case of Edgar and Julia Flores, a couple from Illinois whose Tax Court case was decided in January of 2015. During 2011, Edgar and Julia owned a townhouse approximately 17 miles from their primary residence. They rented out the townhouse or held the property out for rent throughout the entire year. Edgar managed, renovated, and repaired the property, doing all of the work himself.

Julia worked full time, at least 1,800 hours, for Chicago Nut & Bolt Co., Inc., a manufacturer of industrial and intricate custom fasteners whose business does not include the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. She was also the treasurer of the Bill George Youth Football League. Edgar worked at least 1,294 hours for AC Pavement Striping Co., which provides specialized pavement markings and cost-effective pavement preservation practices for all types of roadways. Like Chicago Nut & Bolt, AC Pavement Striping’s business does not include the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property.

On their Schedule E, Edgar and Julia reported $15,648 of rental income and $26,138 of expenses. The expenses consisted of $250 for advertising, $150 for cleaning and maintenance, $970 for insurance, $130 for legal and other professional fees, $300 for management fees, $15,085 for mortgage interest, $3,688 for taxes, $5,015 for depreciation, and $550 for other expenses.

The couple contended that Edgar was a real estate professional. Edgar’s employer was not engaged in a real property trade or business; even if it was, Edgar’s work there would not count toward his status as a real estate professional because he was not a 5% owner. Since he spent 1.295 hours working for AC Pavement Striping, he had to show that he spent more than that amount of time on real estate trades or businesses to qualify for the first prong of the test.

In order to prove their case, the couple introduced into evidence a calendar that identified the dates and times that they contended Edgar spent working on the townhouse. They also produced a summary that computed on the basis of the calendar the total number of hours he worked. According to this calendar and summary, Edgar spent a total of 799 hours working on the townhouse.

They also introduced a log into evidence. Edgar testified that the hours in this log consist of time spent traveling, performing bookkeeping and maintenance, and researching other properties to purchase and rent out. He admitted, however, that the entries indicating that he spent four hours doing bookkeeping were inaccurate.

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They also testified about a second calendar that they claimed identified additional hours that were not included in the first calendar. Unfortunately, Edgar’s testimony about the second calendar was inconsistent with the first calendar. According to his testimony, there are more hours identified in the second calendar and they reflected the hours of both the first calendar and the log that were admitted into evidence.

The court was confused by Edgar’s testimony, deciding that they could not tell from it how he spent his time at the townhouse. The entries in the first calendar and the log were vague. Their estimates were uncorroborated and did not reliably reflect the hours that Edgar spent working on the townhouse. Ultimately, the court did not find Edgar’s testimony to be credible.

Even if the court were to assume that the first calendar and summary were correct, Edgar did not spend more time working on the property than he did as an employee of AC Pavement Striping Co. Therefore, he did not qualify as a real estate professional and there was no evidence that Julia did. As a result, the couple’s rental real estate loss deduction was disallowed pursuant to the passive activity loss rules.

Bill Lewis, a disabled Vietnam veteran from California, had better luck when his case was decided at the end of 2014.During his service in the Marine Corps, Bill sustained injuries that left his right arm 50% disabled and his feet 30% disabled, requiring him to wear orthopedic shoes. The Department of Veterans Affairs determined that he was 60% disabled, and he received monthly veteran’s disability assistance. At the time of his Tax Court case, he was also in need of knee replacement surgery and had difficulty seeing. Bill was 63 years old.

Bill and his wife owned a triplex apartment that is next door to their residence. They began renting out the triplex units to tenants in 2007. For two years the Lewises experienced losses from the triplex that they deducted on their return. The IRS asserted that these were passive activity losses and could not be deducted until the triplex was disposed of.

Bill and his wife did not permanently employ anyone to aid in the process of renting out the units or maintaining the property. Rather, Bill personally performed the administrative tasks, routine maintenance, and repairs. During the years in issue, he was available to his tenants 24 hours a day when they had a lockout or needed repairs. He also collected the rent checks. Each of the tenants paid his or her rent on a different day of the month. When Bill collected each tenant’s rent he would drive to the bank to deposit the funds. Upon his return home, he would log the payment in his computer records. He also spent time each month performing various computer tasks, including generating notices and correspondence with tenants. During the year in question, he also spent time instituting an unlawful detainer action against one of his tenants.

Bill performed the same weekly routine during each of the years in issue without ever taking a vacation. Each morning he would walk around and inspect the grounds for trash left behind by the homeless population. On Mondays, he would clean the washhouse that was in back of the property. On Tuesdays and Fridays, he would landscape and clean the outside of the buildings, the garbage cans, and the front yard. Depending on the season, this chore would also require him to rake fallen leaves from the several walnut trees and sweep the fallen walnuts and shells left behind by squirrels. On Wednesdays, he would take all of the recycling bins one by one to the curb. On Thursdays, he would retrieve the recycling bins, one by one, that he placed at the curb the night before.

The tenants would contact Bill whenever they had a complaint or a repair request. Bill would then schedule a repair. Upon arrival, the repair person would knock on Bill’s door and he would lead the repairperson to the unit needing the service. Upon completion of the repair, Bill would inspect the work or confirm with the tenant that it had been completed properly. During the year in question, he facilitated the repair of a faulty toilet, a clogged kitchen sink, and a broken heater. He also facilitated the repair of a faulty heater, a leaking gas pipe, a broken glass window, a faulty electrical wire, and a faulty oven.

Bill and his wife also evicted one of their tenants who was a smoker and who had left the four-bedroom apartment in poor shape and with brown residue all over the walls. Bill spent time scrubbing the walls clean and otherwise preparing the unit for a new tenant. Additionally, he facilitated the installation of the new carpet by researching the

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carpet, purchasing it, preparing the unit to have the carpet removed, scheduling and overseeing the carpet removal, and then scheduling and overseeing the installation of the new carpet.

Given the fact that Bill was not otherwise employed, he clearly spent more than half of his personal service time on the rental property; the only remaining question as to the first prong of the test was whether his activities constituted material participation. In that regard, Bill testified that he performed almost all of the necessary work related to the rental of the triplex himself. He collected the rents, maintained the property daily and weekly, and handled all maintenance requests. He did not have any employees. At times Bill hired contractors to perform specified work; these instances were infrequent and insignificant compared to the daily work that he performed.

As a result, the court found that Bill satisfied this test because his participation constituted substantially all of the participation in the rental of the triplex. Because Bill was a creature of habit he was able to show that his activities were regular, continuous, and substantial. That left only the 750 between the Lewises and their loss deduction.

While there was no contemporaneous daily report, Bill and his wife each provided the Tax Court with a narrative summary regarding Bill’s activities and the approximate number of hours spent performing those activities. They testified that all of the activities took Bill significantly longer than usual because of his disabilities.

Regarding his routine repair activities, Bill testified that his daily morning inspection of the property took at least half an hour, or 3-1/2 hours each week. He testified that his Monday washhouse cleaning took three hours as it required him to haul a heavy bucket of water and perform the manual labor of cleaning. He testified that each Wednesday it took him at least an hour to haul all six of the recycling bins from the back of the triplex to the curb and that it took the same amount of time each Thursday to return them. He testified that his landscaping and cleaning activities each Tuesday and Friday also took two hours or more, depending on the season. He followed this set routine, week after week, without taking any vacations.

In addition to their testimony, the couple also provided receipts verifying the time spent in administrative work. Because each of the tenants paid rent on a different day, as soon as Bill received the rent he would take it to the bank to deposit it and then return home and input the transaction in his computer records. He testified that each of these trips took him about an hour. They also provided records establishing that Bill spent time each year generating various items of correspondence with the tenants, including initiating an unlawful detainer action.

They also produced records regarding specific repairs that were made, establishing that these occasions arose eight times during the years in question. Additionally, Bill testified that he personally prepared a vacant four-bedroom unit for rental by scrubbing the walls, cleaning the unit, and facilitating the purchase and installation of new carpet.

The IRS contended that Bill’s estimate of the time it took him to perform these activities was overstated and that it was highly unusual for the owner of a single property to spend so much time on these activities. The court agreed that the IRS’s contentions could be accurate for most individuals, but pointed out that Bill was in his sixties and was a 60% disabled veteran.

On the basis of Bill’s established weekly routine, the court calculated that he had documented 12.5 hours a week devoted to the triplex, or 650 hours for the year. Adding in 36 hours each year for the 3 hours each month that he spent depositing the rent checks and the additional hours spent on repair facilitation, tenant correspondence, and the other tasks it was clear that Bill easily spent more than the required 750 hours performing services each year. Therefore, he materially participated, was a real estate professional, and the Lewises’ rental activity for the years in issue was not passive for the purpose of section Code section 469.

A comparison of the results in the Flores and Lewis cases reveals how important it is for the taxpayer to document their activities. Often taxpayers have an inflated sense of the time they spend on rental activities and feel that a “ballpark” estimate will suffice. The Tax Court has ruled time and again that such guesstimates will not establish material participation. Furthermore, testimony alone will seldom be sufficient; the taxpayer needs to maintain some type of documentation to corroborate their assertions.

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It should be noted that activity performed in an individual’s capacity as an investor does not qualify as participation in an activity unless the individual is directly involved in the day-to-day management of the activity. Investor-related activities not qualifying as material participation include (1) Studying and reviewing financial statements or reports on operations; (2) preparing or compiling summaries or analysis of the finances or operations of the activity for the individual's own use; and (3) monitoring the finances or operations of the activity in a non-managerial capacity.

For this reason, it is important for taxpayers to document the specific nature of their activities, not just the time spent. A taxpayer named Al Iverson unwittingly provided a case in point. Despite the fact that Al and his wife formed Stirrup Ranch, LLC to run a 42,000 acre Colorado cattle and horse ranch, they were deemed by the Tax Court to be mere investors in the ranch and the losses sustained by the undertaking were held to be passive.

It’s not that Al had no involvement in the ranch. From his home in Minnesota, he would make and receive telephone calls and send and receive emails and faxes relating to Stirrup Ranch matters. He retained for himself Stirrup Ranch check signing authority, although occasionally he would grant a power of attorney authorizing the ranch manager to sign Stirrup Ranch checks. During the years in question, Al made monthly trips to the ranch and while there would assist the ranch manager and ranch hand with various ranch chores, such as mending fences, rounding up cattle, branding, inoculating, and castrating cattle, and cleaning the barn.

The tax advisor obtained by Al was an attorney, a certified public accountant, the director of a regional accounting firm, and a former IRS employee. That advisor concluded that Al materially participated in the ranch activity. The IRS and, more importantly, the Tax Court, disagreed.

Despite the fact that Al’s trips to the ranch were all documented, as were some of his ranch-related activity while in Minnesota, the court cited the lack of “meaningful contemporaneous or other records and documentation regarding specifically what petitioners did on a day-to-day basis and how much time they spent on matters relating to Stirrup Ranch.” The court states that it would have given more credence to the taxpayer’s claims if they had been able to present “extensive files, to-do lists, home and mobile phone records, business plans, project descriptions, instructions to employees, etc.”

A real estate professional may elect to treat all interests in real property trades and businesses as one activity.However, a real estate professional cannot group a rental real estate activity with any other activity. Pam Bailey learned this lesson the hard way.

Pam did not earn a salary. Instead, she operated three rental properties that she and her husband owned jointly. Her father had been a builder and her mother worked with her father as a bookkeeper and an interior decorator. This upbringing gave Pam an “eye” for the housing market, and experience with building codes, architectural plans, and subcontractors. Using mortgage financing and joint-funds with her husband, she was continuously in the market to purchase property with potential for either resale or conversion into income-producing property.

Following this pattern, Pam negotiated the purchase of a fourth single-family rental property and researched a number of other potential single-family rental property acquisitions. One of these rental properties was about 6 or 7 miles from the couple's home. The structures consisted of a 1,200-square-foot, two-bedroom, 3/4-bath front house and a smaller back unit that had been converted from a one-car garage into a separate residential dwelling.

Pam named this combined property “The Inn on Alisal Road”. As the name indicates, she furnished the two units and offered them together or separately for short-term rent to overnight lodgers, usually for about 3 days at a time. Pam provided a coffeemaker and coffee, but guests were responsible for their own meals. Typical guests were repeat customers, most often couples or small groups, who were in town for a wedding or other special occasion. During the year in question, Pam and her husband rented the Inn for 48 nights, with no guests in January and February. June was the most active month with guests on 12 nights. They usually charged $200 or $250 per night.

Pam did not employ a management company. Instead, she operated the Inn herself. Her onsite tasks included: meeting potential guests and cleaning the interior; dusting, vacuuming, washing sheets, ironing, and running water to maintain the plumbing during periods when the Inn was inactive. Petitioner also maintained the exterior, including

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gardening, hand watering the roses, caring for a plum tree and two cherry trees, inspecting the water drip irrigation system, taking out the trash, reviewing the work of lawn service, and periodically cleaning leaves out of the gutters. On average for the two units combined, Pam spent 5 hours per week on the interior and exterior maintenance of the Inn, for a total of 260 hours for the year.

She also worked offsite with respect to the Inn. She would deposit guest payments at her bank. She received telephone calls inquiring about the Inn and calls for reservations. She paid bills and reconciled the bank account. On occasion, she would wash and iron the Inn’s linens in her large-capacity washer and dryer at home. She went to hardware and home improvement stores to buy replacement items, such as light bulbs, a new showerhead, and a new telephone. On average, she spent 5 hours per month offsite related to the Inn, for a total of 60 hours for the year.

She also spent 4 hours during the year refinancing the property. She secured a variable-rate equity loan of $220,250, initially at 5.640%. She used the proceeds in main part to extinguish a 10% fixed rate seller-financed mortgage. In all, Pam spent about 324 hours during the year managing the Inn.

The Baileys also had three other rental properties. In contrast to the short-term guests at the Inn, they sought year-to-year tenants for these properties. As with the Inn, Pam did not employ a management company but instead did all the work herself. She was able to demonstrate that she spent nearly 500 hours during the year on these properties. She spent another 200 hours researching potential acquisitions. Combined with the 324 hours she spent managing the Inn, Pam was well over the 750-hour threshold and so felt confident she could establish her status as a real estate professional.

Respondent does not dispute that petitioner satisfied the first requirement of materially participating in the activities. Among other qualifying factors, petitioner had no other vocation during 2004 and her involvement in the properties was regular, continuous, and substantial. See sec. 469(h)(1); sec 1.469-1988). Therefore, the only remaining issue is whether petitioner performed more than 750 hours of services in “real property trades or businesses” during 2004.

The Baileys properly elected to group all of their properties into one activity, and the IRS did not dispute this. However, the IRS asserted that the Inn was not a “real property trade or business” for purposes of the 750-hour test. If Pam could not include the hours relating to the Inn, then she spent only about 700 hours on her real estate activities and would not satisfy the 750-hour requirement.

The IRS pointed out that an activity involving the use of tangible property is not a rental activity for a year if, among other reasons, the average period of customer use for such property is seven days or less during the year. The parties agreed that the average period of the guests’ use of the Inn was 3 days.

Pam’s activities that are related to the Inn were disregarded for purposes of determining whether she was a real estate professional because the Inn property is not “rental real estate” as defined in the regulations because the average period of customer use for the property was less than 7 days. As a result, it could not be included in the election to treat all interests in rental real estate as a single rental real estate activity. The Tax Court pointed out that the Inn activity was reported on Schedule C because managing a property with a short rental period is akin to running a business. The other rental real estate activities were reported on Schedule E as a separate and distinct activity and generally fall within the purview of Code section 212.

A closely held C corporation is considered a real estate professional for this purpose if more than 50% of its gross receipts, excluding portfolio income, are derived from real property trades or businesses in which the corporation materially participates. For married individuals filing joint returns, at least one spouse must meet all the requirements of a real estate professional exception.

Services performed by the taxpayer as an employee of a company engaged in a real property trade or business do not satisfy the time requirements of the real estate professional exception unless the taxpayer is at least a 5% owner of the employer during the entire tax year. Accordingly, if at any time during the tax year an employee is not a 5%

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The Net Investment Income Tax (NIIT) 25

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owner, only the personal services performed by the employee during the period the employee is a 5% owner will be treated as having been performed in a real property trade or business.

THE NET INVESTMENT INCOME TAX (NIIT)Code section 1411 imposes a Net Investment Income Tax (NIIT) of 3.8% on individuals, trusts, and estates with net investment incomes above certain statutory amounts. The NIIT applies to individuals who have net investment income and modified adjusted gross income in excess of: (1) $250,000 for joint filers and qualifying widows or widowers with dependent children; (2) $125,000 for married individuals filing separately; and (3) $200,000 for everyone else. For this purpose “modified adjusted gross income” is regular adjusted gross income increased by the net amount, if any, of foreign-sourced income that is exempt for regular tax purposes under Code section 911(a)(1). The NIIT also applies separately to trusts and to estates using a threshold equal to the taxable income at which the estate or trust becomes subject to the highest marginal rate. Estates and trusts are subject to the NIIT if they have undistributed net investment income and also have adjusted gross income over the amount at which the highest income tax bracket for an estate or trust for such taxable year. For estates and trusts, the NIIT threshold is $13,050 for 2021.

In general, net investment income for purpose of this tax, includes, but is not limited to:

Interest, dividends, certain annuities, royalties, and rents (unless derived in a trade or business in which the NIIT doesn't apply),

Income derived in a trade or business which is a passive activity or trading in financial instruments or commodities, and

Net gains from the disposition of property (to the extent taken into account in computing taxable income), other than property held in a trade or business to which NIIT doesn't apply.

Thus, the applicability of the net investment income tax is founded on the passive activity rules contained in Code section 469.

This is particularly meaningful for trusts and estates. Most trusts and estates invest for income, or at least to avoid loss, so the passive activity rules per se were not necessarily all that important to them. Previously, it was unimportant to trusts or estates that had no losses from a trade or business to determine whether the income from a trade or business was active or passive. Code section 1411 now requires those trusts and estates to make that determination for purposes of the net investment income tax.

Thus far, however, precious little guidance has been provided on material participation by a fiduciary for purposes of Code section 469. There is sparse legislative history and only two published cases, Frank Aragona Trust v. Commissioner and Mattie Carter Trust v. United States.

In Aragona Trust, the decedent had operated numerous rental apartment buildings and real estate businesses. After he died, the apartment buildings were placed in a trust and his five children continued to operate these activities as co-trustees. The IRS argued that the trustees’ actions as managers could not be counted towards material participation by the trust. The Tax Court disagreed, reasoning that services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.

In Carter Trust, the U. S. District Court for the Northern District of Texas concluded that material participation by a trust in an activity (in that case the operation of a ranch) is to be determined by the aggregate participation of the fiduciaries and the employees and agents of the trust. The District Court held that a testamentary trust satisfied the section 469 material participation standard as a result of the activities of its fiduciaries, employees, and agents.

The applications of Aragona Trust and Carter Trust have been called into question, however, by an IRS ruling issued in 2013. There the IRS considered whether a trust materially participated in the activities of an S corporation. In that case, two trusts owned an interest in an S corporation that owned a qualified subchapter S subsidiary. Each of the trusts had identical governing provisions whereby an individual, his spouse, his children, and grandchildren were the beneficiaries of the trusts and another unrelated person served as the sole trustee of the trusts.

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26 Rental Activities

The individual beneficiary was appointed as a special trustee of the trusts, which authorized the individual beneficiary to control all decisions regarding the sale or retention of the S corporation stock. The individual beneficiary also served as the president of the qualified subchapter S subsidiary and was therefore directly involved in the day-to-day operations of the qualified subchapter S subsidiary. The sole (non-special) trustee of the trusts was not otherwise involved in the operations of the S corporation or the qualified subchapter S subsidiary. The IRS held that only the activities of the non-special trustee could be taken into account in determining material participation. As such, the trust was held not to have materially participated in the S corporation investments.

Both of the cases described above are trial-level cases and the IRS ruling is merely its litigation position. As such, none of this guidance is binding on most taxpayers, leaving open the question of just whose material participation should be relevant to the characterization of trust income as active or passive for purposes of both the passive activity loss rules and the net investment income tax. Until legislation or regulations are adopted to resolve the issue, taxpayers will have to tread carefully in this area.

Glossary 27

GLOSSARY

GLOSSARY

annuities An insurance product commonly used as part of a retirement strategy.

disposition The final settlement of a matter, particularly the giving up of property by way of transfer to the care or possession of another.

distributive share

The allocation of income, loss, deduction or credit from a business to a partner.

dividends The most common type of distribution from a corporation, paid out of its earnings and profits.

intangible property

A commercially transferable interest in property that does not have a physical presence (e.g., computer software, patents, goodwil, etc.).

interest A payment amount determined by the interest rate on an account. As an investor, interest payments represent income earned on cash accounts or fixed and variable rate securities.

material participation

A term that means that the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.

participation Any work done in an activity by an individual who owns an interest in the activity.

passive activities

Any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.

pass-through entities

Special business structure that is used to reduce the effects of double taxation. Pass-through entities don't pay income taxes at the corporate level.

personal service activity

Any business enterprise with the primary purpose of providing personal services. Personal-service activities encompass a wide range of professions, including law, medicine, engineering, design, finance, accounting and even performing arts.

portfolio income

All gross income that is attributable to interest, dividends, annuities, or royalties.

qualifying disposition

A transfer that disposes of the taxpayer’s entire interest in the passive activity to an unrelated party in a fully taxable event.

rental activity Activities in which real property or tangible personal property is used by non-owners and amounts are paid by such non-owners to the owner principally for the use of the property.

royalties A payment to an owner for the use of property, especially patents, copyrighted works, franchises or natural resources.

tangible property

Personal property that can be physically relocated, such as furniture and office equipment.