Discussion:3.8% tax and S-Corp real estate

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Discussion Forum Index --> Basic Tax Questions --> 3.8% tax and S-Corp real estate


Discussion Forum Index --> Tax Questions --> 3.8% tax and S-Corp real estate

Loophole (talk|edits) said:

7 January 2013
Facts: S-Corp owner personally owns the building his S-Corp operates out of. He leases that building to his S-Corp.

1) Is the net rental income subject to the 3.8% medicare tax on investment income? 2) If not, shouldn't the S-Corp owner reduce his rental income to reduce the 3.8% tax?

Captcook (talk|edits) said:

7 January 2013
To the extent that income is greater than $250K, yes.

If the reduction can still be maintained as reasonable rent, yes.

Ckenefick (talk|edits) said:

7 January 2013
I haven't dug into this new law yet...so Capt might very well be right. But this income would be non-passive under the re-characterization rule. As such, it wouldn't be the "passive" variety that the 3.8% tax is aimed at. I gotta believe this is addressed in the legislation...and perhaps Capt has already looked it up.

MarkSC (talk|edits) said:

7 January 2013
Make a grouping election with the S-Corp under section 469.

Captcook (talk|edits) said:

7 January 2013
I should know better than to take an instructor's word at face value. A presentation I attended last month specifically said these were included in NII, which seemed reasonable as the flow-through nature maintains their character as rent even if grouped.

However, I dug into this a little farther and stand corrected. RIA states these rents when connected with an active trade or business are not a part of NII. Mark's suggestion of grouping activities makes sense. The legislation itself states the activity must be passive to qualify. The rent you describe is not passive and wouldn't be included in NII.

TOrahaCPA (talk|edits) said:

7 January 2013
I like the grouping idea for converting self rental income as non-passive under §1411. I'm not sure if it works though. We looked at this a while ago and the self rental rule alone is passive for §1411 because of the way the law is written. You first have to look at whether an activity is a passive activity.

A passive activity means any activity involving the conduct of a trade or business in which the taxpayer doesn't materially participate

If the answer was yes then §1411 applied. Even if later you had a reason to recharacterize. real estate professionals were not passive activities, but then that loophole was closed because of the proposed regs requirement to be a §162 trade or business.

With grouping a "self rental" activity you would have material participation and be a §162 trade or business. Which is interesting because if you don't get hit with the 3.8% they wanted you to get hit with SE tax, and that's not happening.

I think there is a question missing. Of the things being grouped, why are they being grouped, for what purpose? §469 groups activities for the specific purpose of material participation. Will it group them for purposes of attributing §162 trade or business deductions?

MarkSC (talk|edits) said:

7 January 2013
Yes, good observation. I just reread the preamble to the new regulations, and this issue is left open. I think it's reasonable to conclude that a rental activity that is grouped with an active trade or business should itself be treated as an active trade or business under section 162. In fact there is good authority for treating any rental of property as a section 162 trade or business. (Recall the discussions we had when the law was changed and then repealed to require 1099 reporting for landlords and some argued that it was already required under section 162.) Section 162 is very broad. Section 1402(a)(1) (definition of net earnings from self employment)--is also very broad in exempting rental income from SE earnings. The IRS position is that substantial services must be provided for rental income to be subject to SE tax. It will be interesting to see if this position "evolves" over the years with the Medicare tax.

MarkSC (talk|edits) said:

7 January 2013
The preamble does say that a grouping election of rental income with a passive business does not convert gross income from rents into other gross income from a passive business, so presumably the same is true when grouped with an active business. The rental income stands on its own. The grouping election with an active business makes the rental income active under section 469, but then it must be tested under section 162.

Ckenefick (talk|edits) said:

7 January 2013
I don't think any grouping is necessary. I stand for this American Proposition: The IRS cannot have it both ways. They cannot stick us with non-passive self-rental income for income tax purposes and then stick us with a 3.8% "additional Medicare tax" on the grounds that the income is passive for this separate purpose. F that.

Captcook (talk|edits) said:

7 January 2013
I would agree no grouping is necessary to remove a rental of property to your own s-corp from the 3.8% tax.

MarkSC (talk|edits) said:

7 January 2013
Duh, I forgot about the darn self-rental rule. That explains why it wasn't addressed in the regulation except for groupings with a passive business.

TOrahaCPA (talk|edits) said:

7 January 2013
Oh i disagree, there is nothing in the self rental regulations that change the activity to one that is non-passive. The income itself is recharacterized, but the activity is still a passive activity. This maybe the IRS having it both ways, but §1411 applies to income from activities that are a passive activity (within the meaning of section 469) [§1411(c)(2)(A)].

As i said above an activity within the meaning of §469 is any activity involving the conduct of a trade or business in which the taxpayer doesn't materially participate[§469(c)(1)]. This seems to be the starting point for determining a passive activity for §1411, which is beginning to have a totally different meaning for the term "passive activity". The proposed regs are broadening the starting point to include any activity that does not take §162 trade or business deductions.

So if he works the S corp without a grouping this is still a per se passive activity. Captcook's very first answer is the correct one; reduce AGI below 250k, and lowering the rent is a good idea if that's an option.

I say we kick the grouping idea around a little more and see if we can get passed the §162 trade or business hurdle.

TOrahaCPA (talk|edits) said:

7 January 2013
Chris I completely understand the sense of inequity here. This law is bad for real estate people who make money. You would think they had a better lobby.

I think grouping may provide an argument, but still not a slam dunk because rental real estate is an income producing activity giving rise to §212 deductions.

I'm reposting the previous thread we had on defining a §162 trade or business that involves rental real estate because I think it's relevant. [[1]]

Let me know if anyone thinks there is anything for or against this grouping idea.

Ckenefick (talk|edits) said:

8 January 2013
How about this: Don't pay rent.

Ckenefick (talk|edits) said:

8 January 2013
Here's the reg:

(6) Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property— (i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469-5T) for the taxable year; and

(ii) Is not described in §1.469-2T(f)(5).

JAD (talk|edits) said:

8 January 2013
I'm only part way through this 96 page document (the new regs) so I may well be off here, but the regs seem to distinguish between a real estate professional's activities based upon whether those activities rise to the level of a trade/business. If those activities do not rise to the level of a trade/business, then the trade/business exception in Sec. 1411(c)(1)(A) would not apply.

So a real estate professional's profitable rental activities might not be subject to the 3.8%. If the taxpayer does not qualify as a real estate professional, then it seems to me that the net rental income must be subject to the tax. The trade/business exception obviously does not apply in that situation.

Grouping the S corp with the rental seems like the only game in town.

Ckenefick (talk|edits) said:

8 January 2013
I don't think that's the only game in town and I don't understand what effect grouping a profitable rental will have, given the self-rent reg.

Captcook (talk|edits) said:

8 January 2013
Just as Chris pointed out in the reg, the rental to your active trade or business is deemed non-passive. This tax is only applied to passive activities.

TOrahaCPA (talk|edits) said:

8 January 2013
The reg cited does not change the activity to nonpassive. Read it. It says the INCOME is treated as from a nonpassive activity.

JAD (talk|edits) said:

8 January 2013
I don't think that the definition of passive per Sec 469 is controlling for purposes of determining whether Sec 1411 applies. Net investment income includes a number of income sources that are not passive under Sec 469. My understanding of the regs (so far) is that rentals can be net investment income regardless of whether the rents are passive under Sec. 469. If the taxpayer is not a real estate professional or if he is but his rental activity does not rise to the level of a trade or business, then I believe that the 3.8% tax applies. I'm not sure if grouping would solve the problem, but it might be a strategy to explore.

Ckenefick (talk|edits) said:

9 January 2013
The reg cited does not change the activity to nonpassive. Read it. It says the INCOME is treated as from a nonpassive activity.

You've made that comment before and it is..........debatable. First, it doesn't say the income is non-passive. It says the income is treated as "not from a passive activity." In other words, this is a sentence wherein the classification of the income is contingent and dependent on the classification of activity. (This is how it works with passive activities. The activity gets classified as either passive or non-passive and the income or loss follows that classification). The sentence actually makes no reference to the classification of the income per se, which is to be expected, based on the immediately preceding parenthetical sentence. Rather, the sentence says, "as not from a passive activity." Second, the passive rules are all about activities, are they not?

My understanding of the regs (so far) is that rentals can be net investment income regardless of whether the rents are passive under Sec. 469.

That would be an improper understanding.

TOrahaCPA (talk|edits) said:

9 January 2013
Chris - the checkpoint editors and bna editors have both said that the self rental reg doesn't change the activity from a passive activity. In determining why I found the explanation in this case- Tony R. Carlos, et ux., 123 TC 275.

Originally I was not exactly correct in my reasoning, but this case explains why the activity still remains passive under the self rental rules.

from Carlos, supra

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes net rental activity income from an “item of [pg. 281] property” rather than net income from the entire rental “activity”. Both section 469 and the regulations thereunder clearly distinguish between net income from an “item of property” and net income from the entire “activity”, 8 which might include rental income from multiple items of property. 9 Under the authority of section 469(l)(2), the Secretary could have implemented regulations to remove items of gross income equal to net income from the entire activity, but the Secretary instead implemented regulations to recharacterize net income from a specific item of self- rental property. The use of the term “item of property” leads us to conclude that respondent's interpretation of the regulation is correct. Accordingly, in the instant case, self-rental income from the Bear Valley Road property is removed from the passive activity loss computation, leaving no passive income to be offset by the passive loss on the John Glenn Road property.

Section 469(d)(1) defines passive activity loss as the excess of losses from passive activities over income from passive activities. Consequently, recharacterization of “self-rental income” under section 1.469-2(f)(6), Income Tax Regs., as not from a passive activity effectively removes the income from the passive activity loss computation. Removal of a single item of income from such computation does not affect the passive characterization of items remaining within the activity. See Shaw v. Commissioner, supra. “Under the self- rented property rule, the net rental income from self-rented property is treated as nonpassive income and the net rental losses are treated as passive losses, even though the rental activities are passive activities.” Id.

Ckenefick (talk|edits) said:

9 January 2013
Now, I did use the word "debatable" - There are others, including myself, who would not "completely" agree with the conclusion drawn by BNA and RIA. I am not saying that you're wrong, or BNA/RIA is wrong, but I don't think it is completely clear-cut. When one recharacterizes - or whatever we want to call it - income from an "activity," the implication is that the overall activity has been recharacterized. We can split hairs all we'd like, by getting into this "item of property" nonsense, as did the court (improperly IMO) in Veriha, but if the "item of property" is a building, and that's what rent is being paid for, then the entire activity is the leasing of the building. Not only is it inequitable to treat the income as non-passive for 469 purposes, and passive for the 3.8% tax, it just doesn't make a whole lot of sense. Again, in my view, the IRS can't have it both ways. Section 1411 does indeed reference 469 with respect to this issue.

I am familiar with Carlos. The "item of property" issue contemplates the situation when an activity might involve a taxpayer renting multiple properties under one veil, or one activity per-se, but some of said property is self-rental and some isn't. And note in Veriha, there were 125 leases. Arguably, 125 "items of property" - did the court/IRS say, "Let's look at each one...profitable ones are non-passive, loss ones are passive?" No, the court did not, only because the IRS didn't pursue it. But the court botched this case on many other counts.

TOrahaCPA (talk|edits) said:

9 January 2013
If the income from an item of property is recharacterized to not from a passive activity. What does that do to the classification of the activity as a whole. The self rental rule doesn't automatically carve out a new sub-activity. And when analyzing §1411 it looks to the activity as a whole. I know of no guidance on this issue with respect to §1411.

However, on to new stuff. I think a grouping is necessary, you may not need one, but I think it would be better. When guidance comes my opinion could change. What I think is more important is that you still may have an issue with not being a 162 trade or business, and I don't think grouping activities will cure that. This is what I really would like to steer this discussion toward because if grouping doesn't help here the whole discussion is moot. Obviously we can overcome passive activity issue with a grouping, and possibly even without one, but does that mean in the OP scenario we can then exclude rental income from NII? Wouldn't we be ignoring the economic substance and form of the rental arrangement?

MarkSC (talk|edits) said:

9 January 2013
I think that the spirit of the regulation is that the self rental activity will be deemed active under the Medicare regulation. I think we are parsing the rule too fine to try to draw a distinction between "passive income" and a "passive activity" in this context where there is only one source of the rental income. It would be quite unjust to hold otherwise. I agree with Ckenefick that the entire activity is the rental income from one building so the rental activity must have the same character as the rental income. As I mentioned above, a grouping election would be an easy way to avoid the whole issue. It would be silly for IRS to require that extra step when it's really not necessary.

TOrahaCPA (talk|edits) said:

9 January 2013
I see your point.

MarkSC (talk|edits) said:

9 January 2013
As for the issue of whether the activity rises to a section 162 trade or business, we are fortunate that the section 162 definition is quite broad. Some court cases have held that even a single rental constitutes a section 162 trade or business (note that this does not mean that the income is necessarily subject to SE tax). The preamble to the regulations discusses this issue in the context of a RE professional election. I would be wary assuming that a single rental by a RE professional is a trade or business, but much less wary concluding that a self rental to an active trade or business is itself a trade or business. I haven't researched it, but it just seems common sense. Why should a rental activity lose its character as part of a trade or business simply because it is owned in a separate entity and self-rented? Again, the grouping election would make the connection even clearer, but that seems like an unnecessary step.

JAD (talk|edits) said:

9 January 2013
Not only is it inequitable to treat the income as non-passive for 469 purposes, and passive for the 3.8% tax, it just doesn't make a whole lot of sense. Again, in my view, the IRS can't have it both ways. Section 1411 does indeed reference 469 with respect to this issue.

Sec. 1411(c)(1)(A): Net investment income includes rents. If the rental activity does not rise to the level of a trade or business, then Sec. 1411(c)(2) is not applicable. That is where Sec 469 is referenced.

If the rents are not a trade/business, then they are just like the other types of net investment income such as interest and dividends: still included as NII, and the passive rules are not relevant.

All based upon my reading so far. I will keep this issue in mind and post specific references from the regs as I work my way through them.

Ckenefick (talk|edits) said:

9 January 2013
The 162 issue is a given, as Toraha notes.

But, let's suppose we move beyond that issue...let's say we have a 162 trade/business. Then, the "passive/non-passive" thing becomes completely relevant.

JAD (talk|edits) said:

9 January 2013
Yes, agreed. If the rental is a 162 trade/business, then the passive/nonpassive thing makes the difference. I don't think that the IRS believes that the 162 issue is a given. If they did, they would not discuss the issue in the preamble.

Ckenefick (talk|edits) said:

9 January 2013
Ummm...Congress is the one that gave us the issue. So, the IRS (and us) have to deal with it. The ISSUE is a given, not the answer that we might arrive at for a particular client.

TOrahaCPA (talk|edits) said:

9 January 2013
I hate to beat a dead horse, but the issue we've been discussing, self rental passive or nonpassive, was addressed in the proposed regs. Why didn't anyone tell me and spare me the hair splitting analysis?

The PreRamble basically says that they will honor nonpassive treatment provided by the self rental rule (ie. exclude income from NII)if the activity that gives rise to the rental income is derived in the ordinary course of a trade or business.

It's good to know that there was no inequity after all.

Ckenefick (talk|edits) said:

9 January 2013
There's definite potential inequity. We have non-passive income for income tax purposes...so a logical person would conclude: End of Story with respect to the 3.8% tax. No 3.8% tax. The 3.8% tax only applies to passive types of income, we would think. Yet, we now have to jump through another hoop.

Noj (talk|edits) said:

10 January 2013
I think grouping is required, if materially participating on the other side. Or bring the rent down. Which is probably going to happen in a lot of these cases. Then when they make UTI on S corp subject to social security the rent will go up!!??? I am closing in on the end of my career - you guys should all triple your fees right now. The code is way beyond an easy read and now the IRS wants you to be an unpaid representative (under cover) for them.. So get paid from whatever source you can.

Bobstatax (talk|edits) said:

10 January 2013
So, let's say there's no grouping and S-Corp pays little rent and creates a loss. Can that loss offset other rental income and lower the Medicare tax?

Ckenefick (talk|edits) said:

10 January 2013
I think so.

TOrahaCPA (talk|edits) said:

10 January 2013
Bobstatax I think so too. Who would've thought taxpayers would ever start trying to create passive losses. Lol

MarkSC (talk|edits) said:

10 January 2013
Yes, as long as the rent is indeed at FMV. IRS in the preamble discusses how they will attack transactions designed to create negative NII.

MarkSC (talk|edits) said:

10 January 2013
"I hate to beat a dead horse, but the issue we've been discussing, self rental passive or nonpassive, was addressed in the proposed regs. Why didn't anyone tell me and spare me the hair splitting analysis? The PreRamble basically says that they will honor nonpassive treatment provided by the self rental rule (ie. exclude income from NII)if the activity that gives rise to the rental income is derived in the ordinary course of a trade or business."


I don't read it quite that way. The preamble refers to a test of the "item of income" for trade or business status--not the activity of the lessee. It states, "For example, if a taxpayer has gross income from rents from an activity described in 1.469-2(f)(6) [the self rental rule] that is not derived in the ordinary course of a trade or business, the gross income from rents will be subject to section 1411."

The problem is that 1.469-2(f)(6) applies only to property that is "rented for use in a trade or business" in which the taxpayer materially participates. So IRS seems to be saying that the rental income must stand on its own as a trade or business and can't piggyback on the status of the lessee business. Otherwise, they would have just said that all rent income subject to 1.469-2(f)(6) is exempt from the NII tax.

In any case, it's hard to think of a self rental activity that would not meet the trade or business test. The only one I can think of is a self rental for below FMV that produces a loss (for example, if the rent is sufficient only to pay the taxes). There is a Tax Court case (Yanow v. Commissioner) holding that is not a trade or business, but we're only concerned with positive rental income for the Medicare tax, so that's not very relevant. I can't think of another example of a clearly non trade or business self rental. Maybe a house or something where there was a question of personal use or profit motive?

TOrahaCPA (talk|edits) said:

10 January 2013
I agree.

MarkSC (talk|edits) said:

10 January 2013
This is a perfect example of how the tax code never becomes simpler--only more complex. Why couldn't they just increase the marginal rates and be done with it? I thought it was because the Medicare tax money is earmarked for the Medicare trust fund, but no, the preamble explains that it goes into the general fund so it's not really a Medicare tax at all.

Ckenefick (talk|edits) said:

10 January 2013
From the Code:

(c) Net investment income For purposes of this chapter— (1) In general The term “net investment income” means the excess (if any) of— (A) the sum of— (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2), (ii) other gross income derived from a trade or business described in paragraph (2), and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over (B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

Here's what Paragraph 2 says:

(2) Trades and businesses to which tax applies A trade or business is described in this paragraph if such trade or business is— (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in section 475 (e)(2)).

I think we've agreed that there's a trade/business requirement with respect to the rental activity.

Then, it says NII normally includes rents, but NII will not include those rents *not* described in paragraph 2. Well, non-passive rental income from a self-rent (non-passive) activity is *not* described in paragraph 2. Paragraph 2 only describes income from a passive activity.

If the Code language is clear - it even references 469 - why do we need regs to tell us anything on this issue? Well, we really don't.

Captcook (talk|edits) said:

10 January 2013
That's what I was trying to say above, but didn't cite the code. I should have.

Ckenefick (talk|edits) said:

10 January 2013
In any case, it's hard to think of a self rental activity that would not meet the trade or business test.

It's kinda hard to find an actual definition of a trade or business...

MarkSC (talk|edits) said:

11 January 2013
Well, we did have the debate about whether paragraph 2 might apply because the self rental rule makes only the income rather than the "activity" nonpassive; however, the regs seem to have resolved that since the preamble refers to a self rental being a nonpassive "activity".

Ckenefick (talk|edits) said:

11 January 2013
however, the regs seem to have resolved that since the preamble refers to a self rental being a nonpassive "activity".

Truly, the regs didn't "resolve" anything here. There merely corroborated the truth.

JAD (talk|edits) said:

17 January 2013
So, let's say there's no grouping and S-Corp pays little rent and creates a loss. Can that loss offset other rental income and lower the Medicare tax?

The net loss is passive, right? Therefore suspended, and it doesn't lower the base for the assessment of the tax.

If the taxpayer is a real estate professional, and the rental activity rises to the level of a trade/business, then it is excluded from the tax.

If the taxpayer is a real estate professional, and the rental activity does not rise to the level of a trade/business, then it seems like that loss would reduce other income that is net investment income. There is a limitation on using capital losses to reduce NII, but I haven't seen anything saying that we can't use nonpassive losses from rental real estate to reduce NII. Sec 1411(c)(1)(B) doesn't limit the deductions to the amount of the gross income.

MWPXYZ (talk|edits) said:

25 March 2013
For anyone researching this issue, the February issue of Tax Advisor has an article by Daniel Rowe which addresses these issues. I see he even uses cites.

Trillium (talk|edits) said:

25 March 2013
I think MWP may be referring to Activity Grouping: The Impact of Recent Developments (may be gated).

Terry Oraha (talk|edits) said:

25 March 2013
Thanks MWPXYZ

Rupert (talk|edits) said:

27 November 2013
TD 9644 Final Regs http://www.ofr.gov/OFRUpload/OFRData/2013-28410_PI.pdf


However, the Treasury Department and the IRS appreciate the concerns raised by the commentators. Therefore, the final regulations provide special rules for selfcharged rental income. The final regulations provide that, in the case of rental income that is treated as nonpassive by reason of §1.469-2(f)(6) (which generally recharacterizes what otherwise would be passive rental income from a taxpayer's property as nonpassive when the taxpayer rents the property for use in an activity in which the taxpayer materially participates) or because the rental activity is properly grouped with a trade or business activity under §1.469-4(d)(1) and the grouped activity is a nonpassive activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as nonpassive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a nonpassive trade or business.


Section 1.1411-5(b)(2) of the final regulations provides clarification regarding the interaction between the net income recharacterization rules under section 469 and the section 1411 rules. For purposes of section 1411, the final regulations generally follow the section 469 characterization of the income and gain, particularly the treatment of the items as portfolio income. Section 1.1411-5(b)(2) of the final regulations provides that, to the extent that income or gain from a trade or business is subject to a net income recharacterization rule described in §§1.469-2T(f)(2), §1.469-2(f)(5), or §1.469-2(f)(6), the gross income or gain treated as “not from a passive activity” will not be considered derived from a trade or business described in section 1411(c)(2)(A). In addition, any gain recharacterized as “not from a passive activity” by reason of §1.469-2(c)(2)(iii) is not derived from a trade or business described in section 1411(c)(2)(A) if the gain does not constitute portfolio income under §1.469-2(c)(2)(iii)(F). In the case of recharacterization rules covered by §1.469-2T(f)(10) and §1.469-2(c)(2)(iii)(F), the underlying trade or business remains a passive activity within the meaning of section 1411(c)(1)(A) and §1.1411-5(a)(1).

Ckenefick (talk|edits) said:

27 November 2013
So, can you summarize?

Terry Oraha (talk|edits) said:

27 November 2013
In Summary - It's good for the taxpayer.

Ckenefick (talk|edits) said:

27 November 2013
I really don't see how it could be any other way.

Terry Oraha (talk|edits) said:

27 November 2013
Here's what I was looking for:

To the extent that gross rental income described in paragraph (a)(1)(i) of this section is treated as not derived from a passive activity by reason of §1.469-2(f)(6) ("self rental rule")or as a consequence of a taxpayer grouping a rental activity with a trade or business activity under §1.469-4(d)(1), such gross rental income is deemed to be derived in the ordinary course of a trade or business within the meaning of paragraph (b) of this section.


I don't know if anyone else has been following this, but a grouping of activities generally doesn't group the "trade or business" nature of both activities. I was worried that §162 trade or business would have to be established in both. Now we have comfort Seaside are you following this?

Terry Oraha (talk|edits) said:

27 November 2013
I agree, and if it makes you feel better you called it right on 8 months ago. I know where you stand Chris because if not in this thread or another we talked about it here on TA. However do note that many commentators disagreed with you, and I understand where their reasons were coming from. I've just been waiting for things to get clarified and I'm glad.

Ckenefick (talk|edits) said:

27 November 2013
What! Someone disagreed with me?

With the self-rent thingy, Congress has basically said: Let's pretend the building is owned by your S-corp, instead of being owned by you personally. In such a case, there would be no rent payments involved. Rather, the corp would deduct the operating costs of the building, thereby reducing non-passive income (or increasing non-passive loss) passed through by the S-corp. In such a case, there would be no possiblity to have a passive profit, only a non-passive profit. So, if this is the theory behind the self-rent rule, for income tax purposes, it would be completely inconsistent (and unfair) to ignore this theory for some other tax purpose.

The fact is, there are valid business reasons for holding the RE outside of the corp/partnership. There's the liability issue, the issue of one day selling the stock, the issue of the other shareholder who doesn't want to guarantee the building's bank debt, etc. Nonetheless, in all cases, the Treasury views the self-rent arrangement as potentially abusive, so an across the board rule applies, despite any valid business purpose.

JAD (talk|edits) said:

20 February 2014
Taxpayer operates his business in an S Corporation. He owns commercial property as a single member LLC. We did not group the rental with the business activity because it didn't matter. The rental generated a small profit and was treated as not passive under 1.469-2(f)(6). Under 1.1411-4(g)(6)(i), the rental income avoids being treated as net investment income. In addition, under 1.411-4(g)(6)(ii), if the commercial real estate were sold, the gain would be treated as nonpassive.

Nevertheless, I think that we should now group the rental with the business activity to ensure that the disposition would generate gain that is not treated as net investment income. For example, what if the IRS decided that the rents did not reflect fair market value, readjusted, and the rental wound up generating the loss? If that were in the same year that the property was sold, it seems that that would convert the gain to net investment income.

1. I don't see any downside to grouping the rental with the business activity. Am I missing anything?

2. The situation is further complicated by the fact that the taxpayer only rents part of the property. What I've done in prior years is treat the one building as two separate activities: The one suite rented to the S Corp, which generates nonpassive income, and the other three suites, which are passive. I'm a little uncomfortable with grouping the rental of one part of the building with the S Corp. activity while the rest of the building is treated as passive, although really that’s not much different from what we’re already doing. Following this through, if this building were to be sold at a gain, only a portion of the gain would be treated as net investment income – the portion not grouped with the S Corp. I have not been able to find any case or discussion where an asset is bifurcated this way. Has anyone seen anything?

3. It seems to me that there is an opportunity for planning. If the taxpayer had a property that generated passive income or loss for nine years and in the 10th year, the taxpayer materially participated, and the asset was sold in the 10th year, it seems that the gain avoid the 1411 tax. I’ve read some of the final regs, but not all – has anyone seen anything on this strategy?

Ckenefick (talk|edits) said:

20 February 2014
if the commercial real estate were sold, the gain would be treated as non-passive.

I would like to flesh that out a little more, forgetting about any possible grouping, but just from the angle of the f6 self-rent rule...

Has anyone seen anything?

Reg § 1.469-2T(c)(2)(i)(D), Ex 4.

JAD (talk|edits) said:

20 February 2014
Very nice cite! There’s my precedent for treating the commercial property as two separate assets. Thank you.

For purposes of the passive rules, it seems that grouping is irrelevant. Grouped or not grouped, a portion of the gain on the sale of the commercial real estate will not be passive.

I’m not sure that the same applies for the 1411 tax. 1.1411-4(g)(6)(i) says this:

(6) Treatment of certain nonpassive rental activities.

(i) Gross income from rents. To the extent that gross rental income described in paragraph (a)(1)(i) of this section is treated as not derived from a passive activity by reason of §1.469-2(f)(6) or as a consequence of a taxpayer grouping a rental activity with a trade or business activity under §1.469-4(d)(1), such gross rental income is deemed to be derived in the ordinary course of a trade or business within the meaning of paragraph (b) of this section.

(ii) Gain or loss from the disposition of property. To the extent that gain or loss resulting from the disposition of property is treated as nonpassive gain or loss by reason of §1.469-2(f)(6) or as a consequence of a taxpayer grouping a rental activity with a trade or business activity under §1.469-4(d)(1), then such gain or loss is deemed to be derived from property used in the ordinary course of a trade or business within the meaning of paragraph (d)(4)(i) of this section.


1.469-2(f)(6) is more limited than 1.469-2T(c)(2)(i)(C). 1.469-2(f)(6) applies to the net rental income. It says this:

(6) Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property—

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469-5T) for the taxable year; and

(ii) Is not described in §1.469-2T(f)(5).


Taken together, if it were determined in the year of sale that the rental to the S corporation had generated a loss, then 1.469-2(f)(6) would not apply. If we had not affirmatively grouped a portion of the real estate with the S corp’s business, then we are left with nothing to pull that portion of the gain out of the grip of 1411.

Ckenefick (talk|edits) said:

20 February 2014
Taken together, if it were determined in the year of sale that the rental to the S corporation had generated a loss, then 1.469-2(f)(6) would not apply.

So, forgetting about grouping, let's say we have a self-rental activity and we sell the real estate.

In the year of sale, there is a rental loss. Assuming a gain on sale, would the gain be passive or non-passive? You're saying that the 2f wouldn't apply. Well, it would apply, per se, it's just that it wouldn't act to recharacterize the rental loss since said Reg only recharacterizes income. So, the rental loss would be passive and the gain on sale would be passive, is what I believe you are concluding.

But what if in the year of sale, there is a rental profit...and we sell the property for a gain?

Does 2f recharacterize the gain as well, or is 2f limited to recharacterizing the "net income" from the actual operation of the rental?

JAD (talk|edits) said:

20 February 2014
So, the rental loss would be passive and the gain on sale would be passive, is what I believe you are concluding.

Yes.

If there is rental profit, then 1.411-4(g)(6)(ii) would apply because 1.469-2(f)(6) would have recharacterized the profit as nonpassive, and in that case "such gain or loss is deemed to be derived from property used in the ordinary course of a trade or business..."

Ckenefick (talk|edits) said:

20 February 2014
because 1.469-2(f)(6) would have recharacterized the profit as nonpassive

I hear you, but if you read that stuff really closely, an alternative interpretation might arise.

(A) Treatment of gain. Except as otherwise provided in the regulations under section 469, any gain recognized upon the sale, exchange, or other disposition (a “disposition”) of an interest in property used in an activity at the time of the disposition or of an interest in an activity held through a partnership or S corporation is treated in the following manner:

1.469-2T(c)(2)(i)(A)(1) (1) The gain is treated as gross income from such activity for the taxable year or years in which it is recognized;

1.469-2T(c)(2)(i)(A)(2) (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; and

1.469-2T(c)(2)(i)(A)(3) (3) If the activity is not a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as not from a passive activity.


And from 2f, which you cited above:

1.469-2(f)(6) is more limited than 1.469-2T(c)(2)(i)(C). 1.469-2(f)(6) applies to the net rental income. It says this:

(6) Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property— (i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469-5T) for the taxable year; and (ii) Is not described in §1.469-2T(f)(5).

So then, we have a rental profit in the year of sale with respect to a self-rent activity. Is the activity a non-passive activity in the year of sale? Or, is it a passive activity for which the rental profit has been recharacterized as non-passive?

Ckenefick (talk|edits) said:

20 February 2014
Does the answer hinge on the definition of a "passive activity"...or, is the answer is exactly as JAD says it is and Ck is just loopy?

JAD (talk|edits) said:

20 February 2014
Yikes, I had to copy that into Word and print it out...

I don't think that it matters. Again, assuming no grouping, if we have a rental profit in the year of sale, 1.469-2(f)(6) brings the gain on sale under 1.1411-4(g)(6)(ii), and the portion of the gain related to the portion of the building rented to the S corp escapes 1411.

That's how I read it.

And if there happens to be rental loss in the year of sale, assuming no grouping, taxpayer is SOL and pays 1411 tax on the whole gain.

Do you see any reason not to group that portion of the building with the S corp t/b activity?

Terry Oraha (talk|edits) said:

21 February 2014
We've been through this... I thought a gain or a loss - the portion of the gain related to the portion of the building rented to the S corp escapes 1411. to that I say yes.

I'll have to read what you guys are saying more carefully. brb.

JAD (talk|edits) said:

21 February 2014
Thanks Terry. My thought is that the portion of the building rented to the S corp escapes taxation if (a) the rental generated income or (b) that rental of that portion of the building is grouped with the S corp's t/b activity. If they were not grouped & the rental generates a loss, I read this to say that the gain on the whole building is subject to 1411.

Ckenefick (talk|edits) said:

21 February 2014
I don't think that it matters. Again, assuming no grouping, if we have a rental profit in the year of sale, 1.469-2(f)(6) brings the gain on sale under 1.1411-4(g)(6)(ii),

I suppose, if you believe the cross-reference in the 1411 Reg to the 1.469-2(f)(6) Reg is valid one...

Here's how Congress defined passive activity:

The term “passive activity” means any activity—

469(c)(1)(A)(A) which involves the conduct of any trade or business, and

469(c)(1)(B)(B) in which the taxpayer does not materially participate.

469(c)(2)(2) Passive activity includes any rental activity.

Except as provided in paragraph (7) , the term “passive activity” includes any rental activity.

And we all know that (c)(7) involves a Real Estate Professional...

If you think about it, an ungrouped self-rental activity is *not* a non-passive activity. Look at the definition. It is still a passive activity...a passive activity in which the net rental income has been re-characterized as non-passive.

JAD (talk|edits) said:

21 February 2014
I'm going to go with a simple (LOL!!!) reading of the Regs and go with the belief that the cross-reference is valid. This should not have been called the ACA...it should have been called the TPFEA (tax preparer full employment act).

Thanks for the discussion.

Ckenefick (talk|edits) said:

21 February 2014
You might not want to do that if your client needs a big passive gain to absorb all those suspended passive losses.

A $100k passive gain produces a $3,800 Medicare Tax, but perhaps, a $0 income tax if there are passive losses to offset the passive gain.

If the gain is non-passive, you might be looking a $0 Medicare Tax, but a $15k (or $20k or more) federal tax plus a state tax.

Now, I realize that the Medicare Tax is a permanent difference and the passive loss carryforward might otherwise be used down the road...but I suspect when a client is making this decision, he might opt to pay the $3,800 Medicare Tax.

And, I also realize that the client might not have any passive suspended losses...but if he does, you might want to change your position on the matter. Also note that (f)(5) clearly considers gain on disposal.

Ckenefick (talk|edits) said:

21 February 2014
You might not want to do that if your client needs a big passive gain to absorb all those suspended passive losses.

A $100k passive gain produces a $3,800 Medicare Tax, but perhaps, a $0 income tax if there are passive losses to offset the passive gain.

If the gain is non-passive, you might be looking a $0 Medicare Tax, but a $15k (or $20k or more) federal tax plus a state tax.

Now, I realize that the Medicare Tax is a permanent difference and the passive loss carryforward might otherwise be used down the road...but I suspect when a client is making this decision, he might opt to pay the $3,800 Medicare Tax.

And, I also realize that the client might not have any passive suspended losses...but if he does, you might want to change your position on the matter. Also note that (f)(5) clearly considers gain on disposal.

JAD (talk|edits) said:

21 February 2014
Good point, but it would be a complete disposition.

JAD (talk|edits) said:

21 February 2014
Also, even if there were other suspended losses, the example that you cited from above illustrates 1.469-2T(c)(2)(i)(C), which seems to require that in a disposition, the portion of the property that is rented to the t/b activity is treated as not passive anyway. Your cite is broader than the 1411 reg that we've been discussing.

I think. I'm starting to go cross-eyed with this stuff.

Ckenefick (talk|edits) said:

21 February 2014
Good point, but it would be a complete disposition.

Right, but I'm talking about suspended passive losses from other activities, not from the same one. *Those* wouldn't get freed up...

1.469-2T(c)(2)(i)(C), which seems to require that in a disposition, the portion of the property that is rented to the t/b activity is treated as not passive anyway

(c)(2)(i)(C) just says to break it up..."for purposes of applying this paragraph (c)(2)." Elsewhere in (c)(2), (c)(2)(i)(A) to be exact, it says the same thing that it said when I cited it above:

1.469-2T(c)(2)(i)(A)(2) (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; and

1.469-2T(c)(2)(i)(A)(3) (3) If the activity is not a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as not from a passive activity.

It doesn't say, for example, "If the activity is a passive activity of the taxpayer for the taxable year of the disposition [i.e Editor's Note: based on the material participation rules or the automatic/per se passive rental rule], but the net rental income for the year of disposition has been recharacterized as non-passive per stupid reg (f)(6), then the gain is treated as non-passive activity gross income also..."

It does not say that. It specifically refers to "a passive activity" and "not a passive activity." What is or is not a passive activity is not defined with reference to how it's net rental income gets characterized or recharacterized. It is defined with reference to the material participation tests (or to the automatic/per se passive rental rule).

Terry Oraha (talk|edits) said:

21 February 2014
Section 1.1411-5(b)(2)

Application of income recharacterization rules.

1.1411-5(b)(2)(i)(i) Income and gain recharacterization. To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of §§1.469-2T(f)(2), §1.469-2(f)(5), or § 1.469-2(f)(6), such trade or business does not constitute a passive activity within the meaning of paragraph (b)(1)(ii) of this section solely with respect to such recharacterized income or gain.

1.1411-5(b)(2)(ii)(ii) Gain recharacterization. To the extent that any gain from a trade or business is recharacterized as “not from a passive activity” by reason of §1.469-2(c)(2)(iii) and does not constitute portfolio income under §1.469-2(c)(2)(iii)(F), such trade or business does not constitute a passive activity within the meaning of paragraph (b)(1)(ii) of this section solely with respect to such recharacterized gain.

1.1411-5(b)(2)(iii)(iii) Exception for certain portfolio recharacterizations. To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” and is further characterized as portfolio income under §1.469-2T(f)(10) or § 1.469-2(c)(2)(iii)(F), then such trade or business constitutes a passive activity within the meaning of paragraph (b)(1)(ii) of this section solely with respect to such recharacterized income or gain.

Ckenefick (talk|edits) said:

21 February 2014
Your citing the -5 Reg:

1.1411-5(b)(2)(i)(i) Income and gain recharacterization. To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of §§1.469-2T(f)(2), §1.469-2(f)(5), or § 1.469-2(f)(6), such trade or business does not constitute a passive activity within the meaning of paragraph (b)(1)(ii) of this section solely with respect to such recharacterized income or gain

JAD cited the -4 Reg:

(ii) Gain or loss from the disposition of property. To the extent that gain or loss resulting from the disposition of property is treated as nonpassive gain or loss by reason of §1.469-2(f)(6) or as a consequence of a taxpayer grouping a rental activity with a trade or business activity under §1.469-4(d)(1), then such gain or loss is deemed to be derived from property used in the ordinary course of a trade or business within the meaning of paragraph (d)(4)(i) of this section.

Can -2(f)(6) recharacterize what would normally be passive gain, but due to a self rent situation, as non-passive gain?

Terry Oraha (talk|edits) said:

21 February 2014
JADs -4 reg implies that it can.

The way I read it, the -5 reg gives self-rental the nonpassive treatment; then -4 reg says, if you acquire nonpassive treatment from the -5 reg -4 reg will provide the trade or business treatment, allowing the portion of building where the owner materially participates to escape 1411.

Terry Oraha (talk|edits) said:

21 February 2014
actually both refer to (f)(6). If you are an (f)(6) situation -5 gives you nonpassive and -4 gives you T or B.

Terry Oraha (talk|edits) said:

21 February 2014
However, they could be referring to trade or business "gains" and not gain from disposition. Is that what your asking?

Terry Oraha (talk|edits) said:

21 February 2014
Either way I will be shocked to learn that congress intended such a thing. I don't believe that's the case yet.

Terry Oraha (talk|edits) said:

21 February 2014
You know we're fine. The problem before these regs was that with the self rental issue the 469 statute was very ambiguous about whether a self rental was still a passive activity. The regs were supposed to clarify. The preamble to the proposed regs said that it expected these self rentals to be considered nonpassive, but if there was to be a problem it would be with the trade or business requirements. Then we were all happy when the regs went final because they gave the trade or business requirement -4, and -5 made it nonpassive. Now your saying the way they wrote the -5 reg it only makes the operating income nonpassive, not gain from disposition. I don't really know if that's what you're saying. However, now that it's considered nonpassive the gain from disposition is already out of 1411 via 1411(c)(2) Trade or business to which tax applies

Ckenefick (talk|edits) said:

21 February 2014
First, I'm all ears. Second, I think we need to back up here...And, I agree: The 1411 Regs imply that it can be. But, I'm not so sure that it can.

If you follow my logic above, I'm basically saying that -2(f)(6) doesn't "convert" per se passive rental activity to a non-passive activity. So, if we dispose of the property (which, by the way, involves a disposition of the entire activity, assuming no grouping), we need to look to the passive activity income tax rules to ascertain the character of the gain as being passive or non-passive. The passive activity income tax rules speak with specific reference to whether the activity was a passive activity in the year of disposition or a non-passive activity in the year of disposition. There is not a hint that -2(f)(6) works its way into this determination. Again, the -2(f)(6) Reg does not classify an *activity* as passive or non-passive. Rather, it only re-classifies net passive rental activity income as non-passive. Moreover, even in a self-rent situation, -2(f)(6) it has no effect, whatsoever, if the net rental activity income is a loss. This, I think, bolsters my point that the -2(f)(6) doesn't convert an activity, but instead, maybe only converts the final rental profit or loss result.

What defines an activity as actually being passive or non-passive is (1) material participation and (2) in the case of a rental activity, the strict rental rule that calls for automatic (i.e. per se) passive "treatment."

So, given this, if the income tax rules [i.e. the -2(f)(6) Reg] do not convert a passive activity to a non-passive activity, then, even in a self-rent situation, since we're dealing with a rental activity - which is accorded automatic passive treatment (RE Pros aside) - it follows that the gain can only be passive....per what I cited above, wherein the determination is based on the status of the activity, not on the status of the net income:

1.469-2T(c)(2)(i)(A)(2) (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; and

So, if the gain can only be passive, for income tax purposes, I would submit that the 1411 Regs are out of line in implying (actually, stating) that -2(f)(6) can re-characterize said gain from passive to non-passive...and also, to non-passive for Sec 1411 purposes.

Terry Oraha (talk|edits) said:

21 February 2014
I hear what your saying. I have to go to bed now. we'll have to get down to the bottom of this tomorrow. night.

Ckenefick (talk|edits) said:

21 February 2014
Either way I will be shocked to learn that congress intended such a thing. I don't believe that's the case yet.

I was wondering what Congress was thinking as well and I don't have the answer. On the one hand, I'm thinking the idea was to combat self-rent abuse. On the other hand, I'm thinking Congress didn't think about it at all. And, I'm kind of moving towards that latter position for this reason: People have challenged the self-rent Reg time and time again. Why have they challenged it? Because they believed that Congress didn't think 2 seconds about the self-rent situation, and as such, the taxpayers felt that the Treasury exceeded its authority by promulgating the Reg.

Now, if you really really think about this position, it's not all that laughable. After all, as I think I have noted here, we have a disconnect. You see, the Treasury did a back door move by not converting the entire activity, in my view. This might have been viewed as being contrary to the Code. So, what the Treasury instead did was something lighter, something not totally contrary to the Code: Recharacterize the net income only.

Again, I think we have a disconnect here. The gain disposition rules refer back to the *activity* being passive or non-passive...they do not refer to the characterization of the net income as being passive or non-passive. This may have actually been intentional. You see, if Congress says a rental activity is passive, but the IRS, through regulation treats all profit and all gain as non-passive, what they've done is made a Reg that is completely contrary to the Code. If all gain and all profit is non-passive, then the IRS has converted the activity to non-passive status. After all, what else makes up an activity? Nothing. It's the profits and it's the gains. If ALL of it were to be treated as non-passive, I think these arguments about an invalid Reg might hold more water.

Terry Oraha (talk|edits) said:

21 February 2014
This from the Pre-ramble....

TD 9644, Tax on net investment income of individuals., IRC Sec(s). 1411, 12/02/2013

ii. Treatment of Certain Nonpassive Rental Activities

With regard to grouping and recharacterizations, commentators recommended that the final regulations clarify that determining whether income is net investment income should be based solely on its recharacterized or grouped status as nonpassive under section 469 and the regulations thereunder. Although the Treasury Department and the IRS recognize the administrative simplicity of this rule, the Treasury Department and the IRS believe that this rule is too broad as it would 'deem' certain items to be derived in a trade or business when it is unlikely that a section 162 trade or business is present. For example, see § § 1.469-1T(e)(3)(ii)(D) (rental of property incidental to an investment activity) and 1.469-2T(f)(3) (rental of nondepreciable property). Therefore, the final regulations do not adopt this broad approach.


Another option advanced by some commentators is a special rule for self-charged rents similar to § 1.469-7 pertaining to self-charged interest. However, a proposed rule for self-charged rents would be more complex than the rule for self-charged interest because the amount of the net investment income exclusion must take into account the deductions allowed (depreciation, taxes, interest, etc.) that are not present in self-charged interest. A self-charged rent rule would have to exclude from gross income rents in the same way as self-charged interest, and would also exclude a share of the deductions attributable to earning the income. In addition, a rule based on § 1.469-7 would cover only rents within the context of section 1411(c)(1)(A)(i) and would not provide relief from the inclusion of the gain upon the sale of the property from net investment income. Accordingly, the final regulations do not adopt this recommendation.

However, the Treasury Department and the IRS appreciate the concerns raised by the commentators. Therefore, the final regulations provide special rules for self-charged rental income. The final regulations provide that, in the case of rental income that is treated as nonpassive by reason of § 1.469-2(f)(6) (which generally recharacterizes what otherwise would be passive rental income from a taxpayer's property as nonpassive when the taxpayer rents the property for use in an activity in which the taxpayer materially participates) or because the rental activity is properly grouped with a trade or business activity under § 1.469-4(d)(1) and the grouped activity is a nonpassive activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as nonpassive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a nonpassive trade or business

Terry Oraha (talk|edits) said:

21 February 2014
and what about Reg. 1.469-2(f)(9)(iii)(B)

Ckenefick (talk|edits) said:

21 February 2014
Furthermore, in both of these instances, the final regulations provide that any gain or loss from the assets associated with that rental activity that are treated as nonpassive gain or loss will also be treated as gain or loss attributable to the disposition of property held in a nonpassive trade or business

First, that's not really what the -4 Reg says. The -4 Reg says that the gain will be non-passive if it is specifically re-characterized as such under -2(f)(6) specifically:

(ii) Gain or loss from the disposition of property. To the extent that gain or loss resulting from the disposition of property is treated as nonpassive gain or loss by reason of §1.469-2(f)(6) or as a consequence of a taxpayer grouping a rental activity with a trade or business activity under §1.469-4(d)(1), then such gain or loss is deemed to be derived from property used in the ordinary course of a trade or business within the meaning of paragraph (d)(4)(i) of this section.

Second, I would ask again: Does -2(f)(6) really operate to convert gain on the sale of a self-rent activity [which IS a passive activity] to non-passive?

Terry Oraha (talk|edits) said:

21 February 2014
okay nevermind that reg I posted it applies to developers. The -2(f)(6) to my knowledge doesn't recharacterize gain from disposition, so correct me if I'm wrong, but now we need new guidance to clarify the confusion created by the last guidance.

Ckenefick (talk|edits) said:

21 February 2014
and what about Reg. 1.469-2(f)(9)(iii)(B)

Developers...

Ckenefick (talk|edits) said:

21 February 2014
and what about Reg. 1.469-2(f)(9)(iii)(B)

Actually, I believe it applies across the board and is definitional, but those definitions are important. Here's what it says:

1.469-2(f)(9)(iii)(iii) The gross rental activity income for a taxable year from an item of property is any passive activity gross income (determined without regard to §1.469-2T(f)(2) through (f)(6)) that—

1.469-2(f)(9)(iii)(A)(A) Is income for the year from the rental or disposition of such item of property; and

1.469-2(f)(9)(iii)(B)(B) In the case of income from the disposition of such item of property, is income from an activity that involved the rental of such item of property during the 12-month period ending on the date of the disposition (see §1.469-2T(c)(2)(ii)); and

To carry on, if move down to (9)(iv), the definition of "net rental activity income" is provided. Taken together, (9)(iii) and (9)(iv) basically say that the activity's net rental activity income is (1) gross rents (2) plus or minus gain on sale (3) minus rental operating expenses. And note, this is the definition before applying -2(f)(6). So, if we jump back to -2(f)(6), the amount so recharacterized under that Reg is:

An amount of the taxpayer's gross rental activity income [which includes gain on sale] for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property

So, as Terry has pointed out, the "net rental activity income" DOES include gain on sale, pursuant to the definitions outlined above. But, all it tells us is that the gain on sale is subject to recharacterization pursuant to -2(f)(6).

My beef with it, however, is the "other" Reg, which says this:

1.469-2T(c)(2)(i)(A)(2) (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; 1.469-2T(c)(2)(i)(A)(3) (3) If the activity is not a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as not from a passive activity.

The word "is" is used in both places, not "is treated."

This is the conflict that I am trying to point out. We have a re-characterization rule that says gain on the sale of a self-rent property/item/activity is non-passive, but another reg that says it is not.

        • An ungrouped self-rental activity IS a rental activity and IS, therefore, a per se passive activity [RE Pro status aside], albeit one whose income is subject to re-characterization.****

And, for what's it's worth, note the cross reference to 1.469-2T(c)(2)(ii) above...its hard to decide what to make of it.

Terry Oraha (talk|edits) said:

21 February 2014
Well no matter how bad these regs were drafted the commentators requested clarification on this specific issue, including the NY state Bar, the preamble acknowledges that and that they meant to clarify it, I think that somebody was not think it through when they drafted it, but my gut tells me these gains are not going to be subject to 1411 to the extent recharacterization applies, in JAD's case that would be the gain allocable to that portion of the building that has income not from a passive activity.

Ckenefick (talk|edits) said:

21 February 2014
I totally agree. But at the same time, I'm merely throwing out the possibility that, if a client is benefited by taking an alternative approach (i.e. by treating the self-rent gain as passive for income tax purposes and paying the 3.8%), you might be able to legitimately do it.

The normal 469 regs are very, very heavy handed. It was Spellczech who started a Three Part Discussion Series on their unfairness. There are several aspects of these regs that likely exceed what the IRS was allowed to do here.

And do note, all the self-rent cases, at least the ones that I know of, deal with the easy self-rent rule as it applies to operating net rental profits. I have yet to see a case dealing with the issue we have gotten into herein.

If you really think about it, if a guy disposes of an ungrouped self-rental property in an arms length transaction, he is done with the investment. There really is no reason why that gain should be treated any differently than a gain from a non-self rent situation. I think the IRS can legitimately make an argument about funny business happening with the operating side of the equation, but to me, it falls totally flat to extend that theory to a disposition.

DAJCPA (talk|edits) said:

21 February 2014
So, as Terry has pointed out, the "net rental activity income" DOES include gain on sale, pursuant to the definitions outlined above. But, all it tells us is that the gain on sale is subject to recharacterization pursuant to -2(f)(6).

Ck's point aside, I think this is the answer JAD was looking for.

Ckenefick (talk|edits) said:

21 February 2014
JAD had already taken that as a given.

Her question was about grouping.

JAD (talk|edits) said:

21 February 2014
Actually, my post was more about fleshing out the issues, and I’ve been more than rewarded. As to my specific concerns, here’s what I’ve come to:

1. I was worried that I was missing a downside to grouping the rental with the business activity. The downside is that that portion of the gain will be treated as nonpassive. I completely understand Chris’s points about the inconsistency in and potential lack of validity of the regulations. However, I’m not willing to make my client a test case. The fact that this would be a complete disposition and my client’s other suspended passive losses are immaterial makes this downside irrelevant.

2. Chris provided a perfect cite to support the treatment that I have been using and will continue re bifurcating the commercial real estate for 469 and 1411.

3. I still think we have a planning opportunity here, although because of the 5/10 year rule for material participation, the planning would have to be quite long-term. It would be quite a challenge for me to get any of my clients to think that far ahead.

Thanks everyone…have a great Friday!

DAJCPA (talk|edits) said:

21 February 2014
Taken together, if it were determined in the year of sale that the rental to the S corporation had generated a loss, then 1.469-2(f)(6) would not apply. If we had not affirmatively grouped a portion of the real estate with the S corp’s business, then we are left with nothing to pull that portion of the gain out of the grip of 1411.

Maybe I misunderstand, but I looks like JAD brought up the issue that if the S-Corp portion of the rental (the self rental portion) had a loss in the year of sale, then under -2(f)(6) the gain would not be considered nonpassive due the net income from just the rental income and expense being a loss (no reclassification to nonpassive). However it appears that the net rental income from the activity, for -2(f)(6) purposes, includes gain on disposition. This gain, we assume, would bring the "net rental activity income" to a positive. As a result, this net rental activity, which includes the gain, would become nonpassive per -2(f)(6). This would then make the gain nonpassive for purposes of 1411 (again, Ck's argument aside). If this were not true, then grouping would be required to make the self rental portion of the building nonpassive.

Am I off here?

JAD (talk|edits) said:

21 February 2014
However it appears that the net rental income from the activity, for -2(f)(6) purposes, includes gain on disposition.

I'm not seeing that. The reg talks about "gross rental activity", which seems specific to rental income.

If this were not true, then grouping would be required to make the self rental portion of the building nonpassive.

Or the self-rental portion would have to generate net rental income.

Ckenefick (talk|edits) said:

21 February 2014
I know you're not seeing it. Throughout this post, including your original inquiry, you have made a presumption about how these rules operate.

JAD (talk|edits) said:

21 February 2014
Chris, we can parse about where the regs are inconsistent...internally and with other regulations, what Congress did, what they should have done, what the IRS should have issued. The bottom line is that I have to make a decision based upon what we have and move forward. I think that this has been a good discussion. It's gone deep into the regs and tied together, where possible, 469 and 1411, which, of course, are closely related. My original post was the issue that I was wrestling with, and as this discussion developed, so did my understanding. I feel good about what's been discussed and accomplished.

Ckenefick (talk|edits) said:

21 February 2014
Forgetting about Sec 1411 - b/c you don't get there until you get through 469 - It sounded very much to me like your "gain" result was predicated on how the profitability of the actual rental operation (i.e. rents collects minus rental expenses) panned out.

DAJCPA (talk|edits) said:

21 February 2014
I'm not seeing that. The reg talks about "gross rental activity", which seems specific to rental income.

But what about this (from Ck's post above):

Actually, I believe it applies across the board and is definitional, but those definitions are important. Here's what it says:

1.469-2(f)(9)(iii)(iii) The gross rental activity income for a taxable year from an item of property is any passive activity gross income (determined without regard to §1.469-2T(f)(2) through (f)(6)) that—

1.469-2(f)(9)(iii)(A)(A) Is income for the year from the rental or disposition of such item of property; and

1.469-2(f)(9)(iii)(B)(B) In the case of income from the disposition of such item of property, is income from an activity that involved the rental of such item of property during the 12-month period ending on the date of the disposition (see §1.469-2T(c)(2)(ii)); and

To carry on, if move down to (9)(iv), the definition of "net rental activity income" is provided. Taken together, (9)(iii) and (9)(iv) basically say that the activity's net rental activity income is (1) gross rents (2) plus or minus gain on sale (3) minus rental operating expenses. And note, this is the definition before applying -2(f)(6). So, if we jump back to -2(f)(6), the amount so recharacterized under that Reg is:

An amount of the taxpayer's gross rental activity income [which includes gain on sale] for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property

So, as Terry has pointed out, the "net rental activity income" DOES include gain on sale, pursuant to the definitions outlined above. But, all it tells us is that the gain on sale is subject to recharacterization pursuant to -2(f)(6).

Ckenefick (talk|edits) said:

21 February 2014
Those words "gross rental activity" are a bit tricky...and specifically, "rental activity."

Often, we use the words "rental activity" to describe what happened during the period with respect to rental income (rents collected) and rental expenses (amounts paid/accrued + depreciation/amortization). That is, the word "activity" is something that is going on or has gone on - money in, money out.

But, the definitions tell us that this is not a proper interpretation. "Rental Activity" is not referring to inflows and outflows, but is used as a noun, a thing, as in, "Which activity do you like better - dancing or writing?" It's used with reference to a "passive activity" or a "non-passive activity" (the latter of which I suppose you could call an "active activity," maybe).

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