passive & rental activities€¦ · passive. portfolio. non-passive income. page 230. 8. 15:...

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Chapter 15: Passive and Rental Activities

Page 229-254

15: Passive and Rental Activities

Upon completion of this seminar, participants should be able to—

Learning Objectives

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• Define passive and rental activities and related carryovers and dispositions.

• Determine the impact of the 3.8% Net Investment Income Tax (NIIT).

• Determine when to use elections for grouping activities and real estate professionals.

• Apply rules for passive and rental activities for self-charged interest income and mixed use property.

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Key Developments

• Several court cases regarding significant participation. Page 234– TC Memo 2015-240, Leland– TC Memo 2015-59, Lamas

• TC Summ. Op. 2017-1, Makhlouf, worksheets provided were not supported by contemporaneous records. Page 235

• TC Memo 2017-65, Penley, Court finds “contemporaneous” records of taxpayer not trustworthy. Page 238

• TC Summary Op. 2016-23, Moon, able to prove compliance with rental professional tests. Page 239

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Key Developments

• CA 9th 08/04/2016, 118 AFTR, 2d, ¶ 2016-5091, Gragg, failed to prove material participation. Page 239

• TC Memo 2017-68, Windham, failed some issues for real estate professional election, but proved activity hours, court found for taxpayer. Page 241

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I. What’s New

There has been a significant amount of court activity to settle issues associated with IRC 469

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15: Passive and Rental Activities5

II. Net Investment Income Tax (NIIT)Related to Passive Activity

B. The final regulations attempt to take some of the confusion from what is and is not a trade or business activity subject to the NIIT.

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II. Net Investment Income Tax (NIIT)Related to Passive Activity

The Good the Bad and the Ugly

D. Recognized passive losses will reduce AGI and reduce exposure to tax.

E. Taxpayers with suspended losses should consider getting rid of portfolio income and look for a PIG (passive income generator).

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Image courtesy of imdb.com


III. Conceptual Framework

The Passive Activity Loss laws/rules were a creation of the Reagan Tax Reform in 1986 with the intended purpose of discouraging a taxpayer from purchasing loss activities to offset gain activities.The Bucket/BasketPassivePortfolioNon-passive Income

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III. Conceptual Framework

D. The two types of passive activities:

1. An activity that involves the conduct of ANY trade or business in which the taxpayer does not materially participate or

2. ANY RENTAL ACTIVITY unless one of the exceptions apply

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IV. Flowchart for Passive ActivityDecisions

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V. Rental Exception Test – Page 232

VI. Material Participation Test – Page 233

VII. Active Participation Test (Rental Loss) –Page 236

VIII.Self Rental Tests –Page 237


V. Rental Exception Test

The exceptions:1. Average use per rental 7 days or less2. Average use per rental 30 days or less AND

significant personal services are provided3. Extraordinary personal services are provided

by the owner of the property. – See court case4. Rental of property is incidental to its activity,

i.e. gross rental below 2% of basis or FMV –See example at bottom of page

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The exceptions:5. Property made available to customers in

normal course of business6. Self rental property – The taxpayer has an

interest in property rented to “themselves”.

V. Rental Exception Test


VI. Material Participation

The seven tests of material participation(Reg. §1.469-5T(a)) :1. More than 500 hours2. Participation is substantially ALL for activity3. More than 100 hours and no-one participates

more (including non-owners)4. Activity is a significant participation activity

and total for taxpayer in all such activities is greater than 500

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The seven tests of material participation(Reg. §1.469-5T(a)) :5. Material participation in any five tax years of

ten6. Activity is a personal service activity and

taxpayer materially participated in any three years.

7. Facts and circumstances – Taxpayer participates on a regular, continuous, and substantial basis (Must be greater than 100 hours)

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Test 3. - All participants are less than 500 AND no one participates more than anyone else AND the participation level is greater than 100 hours

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Test 3. - All participants are less than 500 AND no one participates more than anyone else AND the participation level is greater than 100 hours, the biggest wins

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Test 4. - Participates in all activities greater than 100 hours but none more than 500 hours. The activities will be aggregated to determine if the taxpayer meets the 500 hour rule.

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B. IRS wants the taxpayer to substantiate their material participation, but how?

While contemporaneous records will establish participation they are not required, other reasonable means can be used:Appointment BooksCalendarsNarrative Summaries (BUT)

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What happens if it is close – Get ready as IRS will bring out the big guns.

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IV. Material ParticipationPage 235-Bonus

Taxpayer beats the “oral testimony” problem of IRC 469In Stefan A Tolin, TC Memo 2014-65 IRS argued the nature of the involvement of the taxpayer in the activity using IRC 469The taxpayer successfully rebutted IRS’s arguments with oral testimony of employees, associates, and others involved in like activitieshaving an association with the taxpayer.



Good News – Spouses can aggregate each other’s time for purposes of complying with the material participation standards – BUT work done must be that normally performed by a business owner.

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VII. Active Participation Test(Rental Loss)

B. The $25,000 of ACTIVE RENTAL LOSSES specially allowed to qualifying (active participant) taxpayers does not change the rental activity to non-passive.

100% of allowance $0 - $100,000Reduced by 50¢ for each $1 of excess income so is ZERO when taxpayer has income of $150,000

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D. Meeting the active participation standard for rental property for the $25,000 allowance

Not a test of time – An issue of bona-fide management, owner must exercise “independent judgment” and not simply ratify the acts of the management company.


VII. Active Participation Test(Rental Loss)

VIII. Self-Rental Tests (Recharacterizations)

Bottom Line of Rule

If loss it is passiveIf gain it is non-passive

Applies when Taxpayer actively participates with the activity (employees too) OR has ownership interest in activity

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When a taxpayer has self rental income subject to recharacterization whether by design or as an operation of the activity heads IRS wins and tails the taxpayer loses.

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Applies to ALL tangible property including personal property, any flow thru retains nature as self-rental

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Self Rental Income CANNOT touch rental losses, different buckets

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The allocationOwner occupied 10,000 sq. ft. building that is self used (i.e. subject to Self Rental Recharacterization rules) in the amount of 4,500 square feet.

Net rental income for building $10,000Non-Passive $ 4,500Passive $ 5,500

Page 238-Bonus



Estate of Stuller, (CA 01/26/2016) 117 AFTR 2d ¶ 2016-379

In an unusual case the court found that a corporation was:

Operating a hobby businessRenting the building from the shareholder Shareholder was subject to taxation on the non-deductible rent payments.

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The IRS is concerned about abuse of status as a Real Estate Professional

To qualify as a real estate professional a taxpayer must:By a show of hands:A. Spend at least 50% of their time in real estate

activity.B. Must spend at least 750 hours annually in real

estate activities.C.Must comply with the material participation

requirements for each individual or grouped property.

D.A, B, and C. 15: Passive and Rental Activities

IX. Real Estate Professionals

To be a real estate professional you must:1. Spend more than 50% of your time in trade AND2. That 50% is greater than or equal to 750 hours.

Page 238



The court found the log not reliable that indicated the taxpayer worked 12.88 hours per day

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IX. Real Estate ProfessionalsAirline Pilot and his spouse claimed to be real estate professionals. The taxpayers produced extensive detailed recordsindicating the activities of the taxpayers, but primarily those of Mrs. Moon. Result – Mrs. Moon did more work than anyone else, worked more than 750 hours in real estate, and more than 50% of her activities were in real estate.

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IX. Real Estate ProfessionalsQuestion before the Court, did the law require that the taxpayer to deduct losses meet the material participation tests:The Court Said – While the taxpayers did qualify as real estate professionals they failed to establish that they were in fact material to the losses in question.

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Be cautious of the traps: The IRS Audit Guide for Passive Activities says:

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It only takes one on a joint return, does not apply when filing MFS, each spouse stands on their own.

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C. A taxpayer with several rental activities can make a grouping election making multiple rentals easier to qualify as actively participatory BUT

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A taxpayer who failed to make the election and qualified: Was still a real estate professional, BUT No grouping election means, each property had

to qualify.

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X. Grouping Activities

The good, the bad and the ugly of separate versus grouping.

Put two activities together and material participation is required only for the whole.

But grouped activities will require the disposition of ALL activities before suspended losses are released.

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What are the standards of activity grouping?In most instances an issue of facts and circumstances but factors given most weight:

a. Similarities and differences of activityb. Extent of common controlc. Geographic locationd. Interdependencies of business with each other

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The grouping of activities requires a disclosure on the initial grouping made. This requirement was effective for tax years beginning after 01/25/2010.

See the Windham case, Page 241, grouping elections must be made.

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C. What cannot be grouped?

Mixing is not allowed –Real property and personal property cannot be grouped unless they are substantial in relationship to each other.

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Disclosure and Consistency RequirementOnce grouped an activity must remained grouped unless: The grouping was inappropriate There is a material change The commissioner says so

In the event the taxpayer makes a determination that a grouping must be “fixed” disclosure must be made with the return

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XI. Suspended Losses and Dispositions

If PALs are suspended on the current year return they are carried forward until:1. There is a net passive income

2. The taxpayer is eligible for the $25,000 (or portion of) loss allowance.

3. The activity is disposed of.

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XI. Suspended Losses and Dispositions

Losses can be freed up when:

There is a LTCG from the disposition of a passive activity.

There is a “complete” disposition of the activity that has an accumulated loss.

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XII. Self-Charged Interest Income

When a taxpayer has loaned monies to a pass-thru entity that passes through passive income the interest income will be deemed to be passive income versus portfolio income.

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XII. Self-Charged Interest Income

How does it work?Will be allocated their relative share of the interest payments as passive subject to limit.

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XIII. Mixed Use Property andRenting Part of the Home

A dwelling is a home (at least partly) if the taxpayer uses the home either:

More than 14 days

Or

More than 10% of the rental use

WHICHEVER IS GREATER

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There is such as thing as tax-free incomeRent your home OR vacation home for less than 15 days and do not report the income AirBNBs are subject to same reporting rules

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The primary issue with vacation rentals is the 7 day or less issue – i.e. no $25,000 rental exception – Materialparticipation versus Activeparticipation



Mixed Use – When a taxpayer has an individual who has a bedroom and shares the balance of the home AND there is NO separate entrance for tenant space.

Issue – Property will be treated as vacation home rental – Operating expenses and depreciation cannot create a loss, these expenses will be carried forward until consumed OR property disposed of.



So the renting out part of your home:

Expenses are allocated to the “business use only” areas. Any areas used by the owner are considered personal use.


passive & rental activities€¦ · passive. portfolio. non-passive income. page 230. 8. 15:...

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