Tax Court Clarifies Passive and Nonpassive Property Income
Tax Court Clarifies Passive and Nonpassive Property Income
The U.S. Tax Court has upheld the IRS’s determination that a taxpayer could not offset one company’s losses from truck rentals against another company’s income from truck rentals in Veriha, 139 TC No. 3.
Although the taxpayer was the 100 percent and 99 percent owner, respectively, of each truck rental business that supplied equipment exclusively to the taxpayer’s wholly-owned corporation, the court found that the losses from one rental business were passive because they were from a rental activity, but the income from the other rental business was nonpassive, based on the material participation self-rental rule under the regulations.
Comment: Under Code Sec. 469, a taxpayer cannot deduct passive losses unless the taxpayer has offsetting passive income. Generally, rental activity is characterized as passive. However, Reg. §1.469-2(f)(6) treats rental income from an “item of property” as nonpassive if the property is rented for use in a trade or business in which the taxpayer materially participates.
The taxpayer was the sole owner of a trucking business, operating as a C corporation. The taxpayer materially participated in the trucking business. Thus, under Code Sec. 469, the taxpayer’s income from the trucking business was deemed nonpassive.
The taxpayer rented trucks from two companies that he controlled: T and J. Company T was an S corporation owned 99 percent by the taxpayer (and 1 percent by his father). T owned only the tractors and trailers that it leased to the trucking business. T entered into 125 separate lease agreements for tractors and trailers under which each monthly rent was independently determined. Company J was a single-member limited liability company, owned solely by the taxpayer. J owned only the tractors and trailers it leased to the trucking business, with which it entered into 66 separate leases.
Each tractor (the motorized component) and each trailer (the towed storage area) was leased as a separate unit. However, the taxpayer intermingled the storage and use of the tractors and trailers, and made no distinction between those owned by the two separate companies. The trucking business paid the expenses for all the tractors and trailers, and insured them under the same blanket insurance policy.
Rental income and loss
In the year under review, Company T’s truck rentals generated net income, which flowed through to the taxpayer and was treated as passive income on his return. Company J’s truck rentals generated a net loss, which the taxpayer also treated as passive. The IRS recharacterized the income from Company T as nonpassive income under Reg. §1.469-2(f)(6), the self-rental rule, which would prevent the taxpayer from offsetting the losses against the income from the truck rentals.
Comment: The self-rental rule is designed to prevent taxpayers with passive losses from setting up a separate leasing business to generate passive income, to offset the losses. Arguably, the taxpayer had bona fide business reasons for operating the leasing companies that rented the trucks, but the court did not consider this factor.
A passive activity is an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. Losses from the activity are known as passive activity losses (PALs).
Code Sec. 469 does not define an activity, but the regulations provide that one or more trade or business activities may be treated as a single activity if the activities are an appropriate economic unit for measuring gain or loss under Code Sec. 469. Identifying an appropriate economic unit depends on the facts and circumstances.
Comment: In applying Code Sec. 469, the taxpayer (or the IRS) must first identify the activity. Only then can the taxpayer’s involvement in the activity (as active or passive) be determined.
Item of property
Reg. §1.469-2(f)(6) recharacterizes as nonpassive income the rental income from an “item of property,” rather than from the entire rental activity. Thus, the regulations distinguish between net income from an item of property and from the entire activity, which could include income from multiple items of property.
The parties disagreed about what was the “item of property.” The taxpayer maintained that the entire collection of tractors and trailers, regardless of its ownership, was a single item of property, and that treatment as a single item was typical within the trucking industry. The IRS countered that each individual tractor or trailer was a separate item of property.
Comment: Under the taxpayer’s approach, income and losses from the rental activity could be netted first, before they had to be characterized as active or passive. This would accomplish the offset of income and losses that the taxpayer sought. Under the IRS approach, income and losses were separate, and the separate income would be recharacterized as active (or nonpassive) under the self-rental rule.
Looking at the ordinary meaning of “item” as an “individual thing,” the Tax Court concluded that each tractor and each trailer was a single item of property. An item is each “thing” in a group of things; a single unit in a collection of objects, the court found.
The court noted that the answer might be different under different facts. But here, the trucking business entered into a separate lease agreement with each company for each tractor and each trailer that it leased, a fact that strongly suggested that the companies viewed each tractor and each trailer as separate items of property.
The court also rejected as irrelevant, and perhaps inaccurate, the taxpayer’s argument that the IRS had taken a conflicting position in an earlier case. The IRS is not bound to treat taxpayer’s tractors and trailers as one item of property, even if it may have done so in another case, the court held.
Comment: Because the IRS did not challenge the taxpayer’s netting of gains and losses within the leasing company that generated income, only that company’s net income was recharacterized as nonpassive, producing a result more favorable to the taxpayer than if income from each tractor and trailer had been recharacterized.
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