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Passive income recharacterization in related-party leases.

Temp. Regs. Sec. 1.469-2T(f)(6) provides a net income recharacterization rule that applies to income from property rented for use in an active trade or business in which a taxpayer materially participates. This rule applies only if the lessor is subject to the passive activity rules; the lessee is a pass through entity; the lease was entered into, extended or modified after Feb. 29, 1988; and the lease generates net taxable income. The regulations are intended to prevent the conversion of active trade or business income to passive income by manipulating the lease terms among related entities.

Example 1:0 is the sole shareholder and materially participates in an S corporation that operates a hardware store. He personally owns the building, which he leases to the S corporation at a fair market rate. Conceptually, all the income generated by this activity should be active business income to O. Without Temp. Regs. Sec. 1.469-2T(f)(6), it is possible to report a portion of this activity as passive income, thereby offsetting other passive losses that O has and correspondingly reducing his otherwise active business income.

The mechanical aspects of this rule become more difficult when multiple entities are involved. The recharacterization must be determined for each activity and for each entity subject to the passive loss rules. Example 2: Partnership ABC consists of three individuals (A, B and C)who own and lease a building to an S corporation in which A and B materially participate. The net rental income must be recharacterized as portfolio income for A and B while the income allocable to C is passive income.

The rental recharacterization rules do not apply if the lessee is a C corporation, even if the individual owners possess all of the corporation's stock; C corporation ownership is not an activity subject to the passive loss rules.

Just as income from operations of self-rented property are subject to recharacterization, so is the gain on sale of such property. Temp. Regs. Sec. 1.4692T(c)(2) determines the passive nature of the property at the time of its disposition or in the 12 months immediately preceding such disposition. An interesting planning opportunity exists for converting the gain on sale of self-rented property into passive income.

Example 3:0, from Example 1, is ready to liquidate the business and sell the real property. Generally, the gain would be subject to the recharacterization rules. Suppose, however, that he first leases the land and building to an unrelated third party for a period of time before selling it. If there are no self rentals for the tax year of the sale, it appears that the entire gain is considered a passive gain, not subject to recharacterization.

The flowchart on page 506 may be helpful in analyzing the operating aspects of self-rented property.

From James J. Donovan 111, CPA, Rubin, Brown, Gornstein & Co., St. Louis, Mo.
COPYRIGHT 1992 American Institute of CPA's
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Author:Donovan, James J., III
Publication:The Tax Adviser
Date:Aug 1, 1992
Words:483
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