Self-rental rule not affected by grouping activities.

The Tax Court has concluded that self-rental income rechararacterized as nonpassive income under Regs. Sec. 1.469-2(f)(6) is not included in the computation of passive activity losses (PALs), even if the self-rental activity is aggregated with the taxpayer's other passive activities under Pegs. Sec. 1.469-4(c).

Facts

P and his wife (collectively referred to as P) owned two commercial real estate properties (B and G). P also owned all of the stock of two S corporatious--a steal company and a restaurant. P leased B to the steel company, and G to the restaurant.

P grouped B and G together to constitute a single "activity." P netted the B income and the G loss on Schedule E, Supplemental Income and Loss, reported the net rental income as not from a passive activity and reported no PAL. However, the IRS disallowed P's net loss on the G property as a PAL, under Sec. 469(a).

Discussion

Sec. 469(a) disallows the PAL of an individual taxpayer. A passive activity is an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. Under Sec. 469(c)(2), however, most rental activities are passive, regardless of material participation.

Regs. Sec. 1.469-4(c) sets forth rules for grouping tax items together to determine what constitutes a single "activity." It provides: "One or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469." Whether activities are an "appropriate economic unit" depends on the facts and circumstances. The IRS concedes that P's grouping of B and G is an appropriate economic unit. The parties, however, dispute the method for computing the PAL within the "activity" grouping.

Loss Computation

Sec. 469(d)(1) defines a PAL as "the amount (if any) by which--(A) the aggregate losses from all passive activities for the taxable year, exceed (B) the aggregate income from all passive activities for such year." A PAL is computed by first netting items of income and loss within each passive activity and then subtracting the aggregate income from all passive activities from aggregate losses.

Sec. 469(c)(2)'s general rule characterizes all rental activity as passive. However, under an exception in Regs. Sec. 1.469-2(f)(6), net rental income received by a taxpayer for use of his or her property in a business in which the taxpayer materially participates is deemed not from a passive activity. This is sometimes referred to as the self-rental rule or the recharacterization rule. P concedes that they "materially participated" in the conduct of both the steel company and the restaurant. However, P contends that the computation of a PAL requires the netting of income and loss from all items of rental property grouped within the Sec. 469 passive activity, and that Regs. Sec. 1.469-2(f)(6) applies to recharacterize passive income as nonpassive after such computation. The Service contends that Regs. Sec. 1.4692(f)(6) requires the removal of self-rental income from the PAL computation; thus, after income from B is properly removed, P is left with no passive income to offset against the passive loss from G. The Tax Court agrees with the IRS's position.

The Tax Court has previously held that Regs. Sec. 1.469-2(f)(6) is not arbitrary, capricious or manifestly contrary to Regs. Sec. 469(1)(2); see Krukowski, 114 TC 366 (2000), aff'd, 279 F3d 547 (7th Cir. 2002); Shaw, TC Memo 2002-35i and Sidell, TC Memo 1999-301, aff'd, 225 F3d 103 (1st Cir. 2000). Regs. Sec. 1.469-2(f)(6) explicitly recharacterizes net rental activity income from an "item of property," rather than net income from the entire rental "activity." Both Sec. 469 and the regulations clearly distinguish between net income from an "item of property" and net income from the entire "activity," which might include rental income from multiple items of property. The activity grouping does not preempt recharacterization of self-rental income under Kegs. Sec. 1.4692(f) (6). Accordingly, self-rental income from the B property is removed from the PAL computation, leaving no passive income to be offset by the passive loss on G, which is disallowed under Sec. 469(a).

TONY R. CARLOS, 123TC NO. 16 (2004)