In general, a passive activity is any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. Passive activity includes any rental activity. IRS provides that a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the activity’s operation on a basis that is regular, continuous and substantial.
An exception to the general rule is the self-rental rule which provides that the taxpayer’s net rental activity income is treated as not from a passive activity if the property is rented for use in a trade or business activity in which the taxpayer materially participates. For purpose of this self-rental rule, the business can be a C corporation, an S corporation, or a partnership. The rule recharacterizes income from profitable rentals as non-passive income, meaning that the passive activity losses from non-profitable rentals could not offset the profitable rentals. It denies taxpayers the opportunity of leasing property to business entities in which they materially participate, and using the net income from such activities to offset passive losses from other source. However, the rental losses are still considered to be passive losses deductible only to the extent of passive income.
If the taxpayer sells the operating-lessee company and the seller continues to lease the property to the unrelated buyer operating the business, can the taxpayer avoid the self-rental rule? It depends. Under the material participation rules, if the taxpayer has materially participated in an activity for 5 out of the past 10 tax years, then the taxpayer is considered to have materially participated in the current year. Thus, even if the operating business remains a separate activity in the buyer’s hands, the taxpayer will continue to be a material participant in the activity after it is sold under the 5-out-of-10-year rule until the expiration of that period.
The new 3.8% tax on net investment income, which applies to certain passive income, makes it more critical than ever for taxpayers to properly identify their passive activities.
If you have any questions regarding the grouping and structuring of real estate and leasing activities, please do not hesitate to contact us