Final regulations deem net income from rental to close corporation nonpassive.

The final passive loss regulations changed a position held in the temporary regulations. Under Regs. Sec. 1.469-4, property rented by a shareholder to a closely held C corporation will be subject to the recharacterization rules. As a result, if the rental activity generates net income, it will be considered nonpassive income; but if it generates a loss, the loss will be classified as passive (except when each owner of the corporation has the same ownership interest in the rental activity; see Regs. Sec. 1.469-4(d)). Based on the temporary and proposed regulations, it was assumed that the recharacterization rules only applied when the rental was to a related flowthrough type of entity.

The final regulations do not change the general rule that rental activity is generally considered a passive activity, nor do they change the major exception to the general ride that self-rented property is only a passive activity if it generates a loss. Self-rented property that generates net income is considered nonpassive. Presumably the purpose of this recharacterization rule was to prevent business owners from being able to create a passive income generator to offset passive losses, by renting property to a controlled entity when arguably the lessor and the lessee are somewhat indifferent to the cost of the lease. The potential for this abuse is most likely in flowthrough entities such as S corporations, partnerships and limited liability companies, particularly when the lessor has a controlling interest in the entity.

The final regulations expand the definition of what constitutes a self-rental situation. Temp. Regs. Sec. 1.469-4T (b) (2) (ii) (B) specifically stated that self-rented property did not include property rented to any C corporation. Final Regs. Sec. 1.469-4(a), however, includes "C corporations that are subject to section 469." Corporations subject to Sec. 469 are those in which 50% or more of the stock is owned by five or fewer individuals (Sec. 469(j) (1)).

Accordingly, individual stockholders who rent property to close corporations when the rental results in net income should report that income on their return as nonpassive. It is important to note that this recharacterization applies regardless of the percentage of the lessee corporation owned by the lessor.

Although this provision may be challenged on the basis that the regulations were changed without being available for public comment, a taxpayer deciding to prepare a return reporting this type of income as passive should consider a disclosure on Form 8275-R, Regulation Disclosure Statement.