The concept of “passive” income has been around so long that few individuals studying for the Enrolled Agent examination are aware that it’s only existed for about thirty years. The focus of EA study regarding passive activities is learning about the layers of tax rules that apply to the subject.
A paramount general consideration about passive activity is that any loss is not tax deductible against ordinary income. This put an end to tax shelters that created losses for investors while holding assets that were expected to eventually gain value. Lacking an immediate deduction of losses makes passive arrangements less attractive investments. As Enrolled Agent review material points out, investors are allowed to deduct accumulated losses when the passive investment is sold and the activity comes to an end.
The one situation that permits deduction of passive losses when incurred is using them to offset gains from other passive activities. Unfortunately, some of the tricks used to create passive gains for offsetting passive losses have been quashed by IRS mandates. This includes some obscure EA training details such as the tax treatment of “self-rental” and “land rent” arrangements.
Now, a new law has triggered additional considerations about passive income. Healthcare reform legislation imposes a 3.8 percent tax on investment income for some high-income individuals. Under the definition of “investment income” for purposes of the new tax is passive income. The determination of passive income according to an Enrolled Agent course is used by subtracting passive losses from passive gains of the current year.
Consequently, a recent Tax Court ruling about passive income has freshly important implications. The taxpayer leased his land containing cell phone towers to an S corporation in which he is the sole shareholder. The corporation then leased the towers to phone companies. A mistake on the corporation’s tax return combined lease income on the towers along with other types of income. Tower lease income should have been separated as a passive rental activity. Instead, the income was treated as non-passive.
However, the taxpayer’s lease to his S corporation of the towers and the land were correctly reported as passive activity. Several tower leases were profitable for the individual and others were unprofitable. He used the passive losses to offset passive income. The IRS challenged the situation by treating the profitable leases as non-passive self-rental and the unprofitable leases as non-deductible passive losses. Plus, the rental income of the S corporation, which passes through for reporting on the shareholder’s personal tax return, retained its classification as non-passive.
The taxpayer didn’t like having passive losses that he could not use to offset against income the IRS said was non-passive. So, he took the matter to the Tax Court, which agreed with him that the IRS is wrong. The taxpayer is not required to divide the various cell tower rentals between unprofitable passive activities and profitable non-passive ones under self-rental guidelines. Just because the corporation failed to report the tower rental to phone companies as passive, doesn’t mean the rental of them becomes a non-passive business to which the self-rental rule applies.
By no longer having the self-rental restriction, the taxpayer can treat his profitable tower leases to the S corporation as passive income for offsetting unprofitable passive lease losses. However, the Tax Court did uphold the land rental as non-passive. If the S corporation had used the towers in its regular business – instead of renting them to phone companies – the court would likely have upheld the taxpayer’s profitable leases as non-passive under the self-rental rule.
The result shows how difficult Enrolled Agent tax work can become when identifying passive income situations. Correctly grouping self-rental and land rental agreements as non-passive is crucial to accurate identification of non-deductible passive losses. The new tax on passive income starting in 2013 makes this exercise even more imperative.
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