The passive activity loss (“PAL”) rules can limit the ability to deduct losses from passive activities, such as rental losses.
The real estate professional and activity grouping rules can allow taxpayers to avoid having their losses limited by the PAL rules.
Earlier this month, the IRS issued AOD 2017-007, IRB 2017-42, to note its formal disagreement with the court’s interpretation of these rules in Stanley v. United States, 5:14-cv-5236 (W.D. Ark. 2015).
The case applies the rules to the interesting fact pattern of an employee who happens to have some limited stock ownership in a related real estate business and an interesting twist on the grouping rules.
The Facts & Procedural History
The court case provides a concise summary of the facts in this case. So unlike other posts, we’ll provide the facts in a quote from the opinion:
In 2009 and 2010, Taxpayer was President Emeritus of Lindsey Management Co., Inc. (“LMC”), a property management company that manages apartment complexes, golf courses, and commercial properties in Arkansas and surrounding states. For 2009 and 2010, Taxpayers reported as non-passive the income and losses from their ownership interests in these entities, as well as from their directly-owned rental real estate. The IRS reclassified the income and losses from these entities as passive. Taxpayers argued that Taxpayer qualified as a real estate professional for purposes of § 469(c)(7) and that they materially participated in their aggregated rental real estate activity. Taxpayers further contended that they should be allowed to treat all of their rental real estate and non-rental trade or business activities such as the golf courses as a single “grouped” activity under § 1.469-4.
To decide the case, the court examined the real estate exception to the passive activity loss rules and the grouping rules.
The Passive Activity Loss Rules
We have previously written about these rules, so no need to reinvent the wheel. This article will use the summaries of the rules from these two articles: real estate professional dispute and PAL grouping dispute.
The passive activity loss (“PAL”) rules were enacted to discourage taxpayers from entering into tax shelters. Many of these pre-1986 tax shelters involved real estate, so real estate was specifically included in the PAL rules. Under these rules, rental real estate is deemed to be passive and any loss is generally limited to other passive income. Unused losses are carried forward indefinitely until there are passive income or the passive activity is sold or disposed of. These rules can prevent a taxpayer who has other non-passive income (such as wages from a job), from taking the passive losses from real estate to reduce non-passive income that is subject to tax.
The Real Estate Professional Exception
The PAL rules include an exception for real estate professionals.
Real estate professionals are individuals who own real estate and who spend more than half of their time during the year tending to the property and who do this for more than 750 hours a year. These rules can be particularly problematic for individuals who have regular jobs or unrelated businesses, as they often will spend more time with their job or business rather than their real estate activities. And IRS employees often do not understand the concept of having two jobs.
This isn’t necessarily true for individuals whose jobs or businesses are related to real estate. The PAL rules define these real estate-related businesses as follows:
the term real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
The IRS has previously issued guidance in 2014 suggesting that this language does not include individuals who work providing financing for real estate that they do not own.
Personal services performed by the taxpayer as an employee are not treated as performed in a real property trade or business unless the taxpayer is a 5% owner of the employer. The rules say that the 5% owner of a corporation is to be proven by owning the stock or voting power of the corporation; whereas, for non-corporations, this is shown by having a profits or capital interest in the employer.
The Stanley Case
The court in Stanley addressed this 5% owner rule. The court concluded that the taxpayer owned 10% of LMC. It reached this determination by examining the taxpayer’s employment agreement. The employment agreement specified that the taxpayer would relinquish his stock upon full retirement. There wasn’t any other evidence that the taxpayer owned this 10% stock interest.
This was what the IRS was disputing in its Action on Decision, i.e., that the mere recitation of a stock ownership in an employment agreement alone is not sufficient to invoke the 5% owner rule. The IRS’s position is that there has to more evidence of stock ownership, as it viewed the taxpayer as a mere employee and not an owner. If the 5% rule did not apply, the real estate activities for LMC would not count for purposes of the real estate professional exception and the losses would be passive.
This case should be compared to cases like Bahas v. Commissioner, T.C. Summary 2010-105. The taxpayer in Bahas was a real estate assistant employed by a corporation and her pay was based on the profits of the corporation. This did not qualify under the five percent owner rule as she did not own stock in the corporation. It would have qualified under the five percent owner rule if the employer was not a corporation.
These types of cases raise the question as to whether an employee can be granted certain minimal ownership rights in a corporation so that the employee can qualify for the real estate professional exception. The Stanley case stands for the proposition that it can.
This is an interesting addition to the passive activity loss rules–one that opens up yet another opportunity for some taxpayers to sidestep the passive activity loss rules (one of the easiest ways to avoid the rules is to have an otherwise unemployed spouse manage the real estate and document their time doing so).
The Stanley case and Action on Decision also address the grouping rules.
The PAL Grouping Rules
The regulations also provide grouping rules. These rules allow taxpayers to group activities for purposes of the passive activity loss rules. They generally ask whether the activity grouping represents an appropriate economic unit. The regulations focus on these factors in evaluating whether grouping is appropriate:
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location;
- Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).
The Stanley Case
The court in Stanley considered whether a real estate professional could group a non-real estate activity with a real estate activity when applying the passive activity loss rules. The court concluded that taxpayers can in fact group non-real estate and real estate activities for this purpose. It reached this conclusion by determining that the limitation on grouping non-real estate and real estate activities only applies to determining whether the taxpayer materially participated.
The IRS’s Action on Decision takes issue with this. It reasoned that the limitation on grouping applies to more than just determining whether the material participation is satisfied, it applies to determining whether there is a passive loss by netting nonpassive and passive income and losses.
Given the highly factual nature of grouping determinations, taxpayers should consult with their tax attorneys to re-evaluate their grouping and passive activity loss options.