Renting Real Estate to a Related Corporation May Cause PAL Rule Tax Problems

The passive activity loss (PAL) rules were enacted as part of the Tax Reform Act of 1986. They were intended to prevent taxpayers from using losses and credits from tax shelters to offset income from such sources as wages, interest and dividends. Congress felt that taxpayers who were simply investors in a business activity (and not actively participating) should use deductible tax benefits only against income from such passive activities.

Rental real estate activities are passive activities subject to the passive activity rules. Losses from rental activities, after including expenses such as interest and depreciation, are not deductible unless a taxpayer has passive activity income from other sources. There is an exception. Taxpayers are generally allowed to take a net deduction of $25,000 from ordinary income if they actively participate in the rental activity. This special rule is phased out for high-income taxpayers.

Taxpayers with passive activity losses have a natural desire to create sources of passive activity income which can be used for deduction of losses from other passive activities. Taxpayers who are doing business as a corporation frequently own the real property which the corporation uses and receive rents from the corporation for the property use. This lease income to their corporation is reported on their individual income tax return as rent income. Taxpayers would normally expect that this income is passive activity income because rental activities are defined as passive activities.

However, the IRS does not like the possibility that a taxpayer could create artificial passive income by renting property to a controlled corporation and use this income to offset losses from other passive activity investments. The sole owner/taxpayer of an S Corporation could also compensate himself through the artificial use of rent and diminish W-2 compensation (which is subject to payroll taxes). To stop this perceived abuse possibility, the IRS recently issued new regulations classifying net rental income from a corporation owned by the taxpayer as active income (and not passive activity income). Therefore, rents from a corporation owned by the taxpayer could not be used to offset losses from other passive activity investments.

But what happens if the rents from the taxpayer-owned corporation result in a rental loss after rental-related expenses? The IRS has said the activity IS a passive activity and losses can only be deducted against other passive activity income. If there is no passive activity income from other sources, the loss cannot be used to shelter ordinary income.

In a recent Tax Court Case ( Senra, TC Memo. 2009-79) the taxpayer argued that a rental loss should be deductible against wages the taxpayer reported from the same corporate activity. The taxpayer argued that the rental activity was related to the business activity of the corporation and, when combined, the two activities formed one economic unit. They argued that it should be treated as a single activity for purposes of measuring gain and loss for netting purposes.

The Tax Court disagreed and said that the passive activity loss rules cannot be escaped under the "one economic unit" argument. The taxpayers were stuck with a rental loss which could not be used to offset wage income from the same corporation. This court case is something to consider when dealing with a related party transaction between a controlling taxpayer and a corporation having rental income.

When dealing with related parties, the water can get murky. 1031 Corporation has information on exchanging properties between related parties and can help you understand the issues that may be present. See our website for information on structuring issues when parties related to each other are buying and selling and making efforts to defer capital gains taxes. Of course, you can always give us a call at 888-367-1031. While we can't advise you on passive activity loss rules, we can provide related party exchange-related consultation...and both the information and phone call are free!