10.9 Passive Income Recharacterized as Nonpassive Income
There is an advantage in treating income as passive income when you have passive losses that may offset the income. However, the law may prevent you from treating certain income as passive income. The conversion of passive income to nonpassive income is technically called “recharacterization.” This may occur when you do not materially participate in the business activity, but are sufficiently active for the IRS to consider your participation as significant. Recharacterization may also occur when you rent property to a business in which you materially participate, rent nondepreciable property, or sell development rental property.
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Caution
“Recharacterization” of Passive Income
Gain on the sale of property used in a passive activity may be recharacterized as nonpassive income if the property was formerly used in a nonpassive activity (10.16).
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Significant participation.
The IRS compares income and losses from all of your activities in which you work more than 100 hours but less than 500 and that are not considered material participation under the law. If you show a net aggregate gain, part of your gain is treated as nonpassive income according to the computation illustrated in the following Example.
EXAMPLE
Carol Warren invests in three business activities—A, B, and C. She does not materially participate in any of the activities during the year but participates in Activity A for 105 hours, in Activity B for 160 hours, and in Activity C for 125 hours. Her net passive income or loss from the three activities is:
Carol’s passive activity gross income from significant participation passive activities of $2,200 exceeds passive activity deductions of $1,500. A ratable portion of her gross income from significant participation activities with net passive income for the tax year (Activities A and C) is treated as gross income that is not from a passive activity. The ratable portion is figured by dividing:
1. The excess of her passive activity gross income from significant participation over passive activity deductions from such activities (here $700) by
2. The net passive income of only the significant participation passive activities having net passive income (here $1,000). The ratable portion is 70%.
Thus, $280 of gross income from Activity A ($400 × 70%) and $420 of gross income from Activity C ($600 × 70%) is treated as nonpassive gross income. This adjustment prevents $700 from being offset by passive losses from another activity.
Net interest income from passive equity-financed lending.
Gross income from “equity-financed lending activity” is treated as nonpassive income to the extent of the lesser of the equity-financed interest income or net passive income. An activity is an “equity-financed lending activity” for a tax year if (1) the activity involves a trade or business of lending money and (2) the average outstanding balance of the liabilities incurred in the activity for the tax year does not exceed 80% of the average outstanding balance of the interest-bearing assets held in the activity.
Incidental rental of property by development activity.
Where gains on the sale of rental property are attributable to recent development, passive income treatment may be lost if the sale comes within the following tests: (1) the rental started less than 12 months before the date of disposition; and (2) you materially participated or significantly participated in the performance of services enhancing the value of the property. The 12-month period starts at the completion of the development services that increased the property’s value.
Self-rental rule: Renting to your business.
If you rent a building to your business, the rental income, normally treated as passive income, may be recharacterized by the IRS as nonpassive income where you also have losses from other rentals. Recharacterization prevents you from deducting the rental losses against the net rental income. Although not specifically written into the law, the recharacterization rules are incorporated in IRS regulations. For the recharacterization rule to apply, you must “materially participate” in the business renting the property; see the following Examples. The Tax Court and several federal appeals courts have upheld the IRS recharacterization rule.
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Caution
Property Rented to Nonpassive Activity (Self-Rental Property)
You may not generate passive income by renting property to a business in which you materially participate. See “Self-rental rule: Renting to your business” in this section.
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EXAMPLES
1. Krukowski, an attorney who operated two businesses through wholly owned C corporations, claimed that the IRS’s recharacterization regulations were arbitrary and capricious. He rented personally owned buildings to the corporations, one of which ran a health club and the other the attorney’s law firm. He reported net income of $175,149 from the rental to the law firm and a $69,100 net loss from the rental to the health club. He deducted the loss from the income and reported net rental income of $106,049. The IRS disallowed the loss offset by recharacterizing the rental income from the law firm as nonpassive income. Recharacterization could be applied under the regulations because the time spent by the attorney in the law firm was material participation. The attorney had to report rental income of $175,149; the health club rental loss was treated as a “suspended” passive loss.
Before the Tax Court, the attorney claimed that the recharacterization rule was arbitrary and contrary to the passive loss statute. The Court disagreed. The law authorizes the IRS to write regulations interpreting the law. Further, Congressional committee reports contemplate that the IRS would define nonpassive income in such a way as to prevent a taxpayer from offsetting active business income with passive business losses.
The Seventh Circuit Court of Appeals affirmed the Tax Court. The IRS was given authority by Congress to enact the self-rental rule as a way of eliminating tax shelters. Three other appeals courts, the First, Fifth, and Ninth Circuits, have also upheld the IRS regulation.
2. Carlos argued that he could avoid the IRS’s self-rental rule by grouping together (10.5) as a single rental activity two rental properties. He operated a steel company and a restaurant through wholly owned S corporations. He leased one of his personally owned buildings to the steel company and another to the restaurant. He had substantial rental income from the steel company lease but a loss on the restaurant lease because the restaurant did not pay the agreed upon rent. On his tax returns for 1999 and 2000, Carlos grouped both properties together as a single activity and on Schedule E netted the loss from the restaurant rental against the net income from the steel company rental.
Applying the self-rental rule, the IRS required the income from the steel company rental to be reported, while disallowing the losses from the restaurant rental. The income from the steel company rental that would otherwise be treated as passive was recharacterized as nonpassive income since Carlos materially participated in the steel company. After the recharacterization, there was no passive income to be offset by the passive losses from the restaurant rental. The passive losses can be carried forward.
The Tax Court rejected Carlos’s argument that his grouping of passive income and loss within a single activity precluded application of the self-rental recharacterization rule. To allow netting in this situation would defeat Congressional intent that a taxpayer not be able to use self-rentals as a means of sheltering nonpassive income from an active business with passive losses.
Rental of property with an insubstantial depreciable basis.
This rule prevents you from generating passive rental income with vacant land or land on which a unit is constructed that has a value substantially less than the land. If less than 30% of the unadjusted basis (5.16) of rental property is depreciable, and you have net passive income from rentals (taking into account carried-over passive losses from prior years), the net passive income is treated as nonpassive income.
EXAMPLES
1. A limited partnership buys vacant land for $300,000, constructs improvements on the land at a cost of $100,000, and leases the entire property. After the rental period, the partnership sells the property for $600,000, realizing a gain. The unadjusted basis of the depreciable improvements of $100,000 is only 25% of the basis of the property of $400,000. The rent and the gain allocated to the improvements are treated as nonpassive income.
2. Shirley offset a passive rental loss from an investment in a limited partnership, LP, which was a substantial owner of a general partnership, GP, against rental income from an investment in a joint venture, JV. JV had leased to GP land on which GP constructed a shopping center. The IRS held that the rental income from JV was nonpassive rental income within the 30% test and could not be offset by the passive rental loss. The Tax Court agreed and also rejected Shirley’s attempt to aggregate her investment activities in JV and LP as one activity. The operations of each group, JV, LP, and GP, were separate and not owned by the same person. She was not the direct owner of any of the units. Further, the aggregation rule does not apply to property falling within the 30% test.
Licensing of intangible property.
Your share of royalty income in a partnership, S corporation, estate, or trust is treated as nonpassive income if you invested after the organization created the intangible property, performed substantial services, or incurred substantial costs in the development or marketing of it. See Publication 925 for further details.
