Rental properties are generally considered passive activities, regardless of whether the taxpayer materially participates, ensuring losses from rental real estate are generally subject to the limitations on passive activity losses (PALs).
One way you cannot generate more passive income to absorb your rental income is to rent to a business you own or materially participate in. Under the "self-rental rule," such income is recharacterized as nonpassive and can't be used to offset real estate rental losses.
Three (3) special passive loss relief provisions specifically aimed at rental real estate activities important to know:
(1) the $25,000 allowance for certain individuals and, for a limited time after an individual’s death under Sec. 469(i) and
(2) the exception to the general rule for real estate professionals under Sec. 469(c)(7).
(3) Contributing Rental Loss Activities to a Profitable Closely-held C Corporation
Individuals must apply the PAL rules to activities they hold personally and in passthrough entities (partnerships, S corporations, and limited liability companies). In addition, the passive loss rules apply to activities held by closely held corporations and personal service corporations (PSCs) (Sec. 469(a)(2)).
While both closely held corporations and PSCs are subject to the PAL rules, closely held corporations are afforded more favorable treatment. Closely held corporations (other than PSCs) can use passive losses to offset net active income, but not portfolio (e.g., interest, dividends) income (Sec. 469(e)(2)). Thus, these corporations do not have to generate passive activity income before passive losses can be deducted.
When applying the PAL rules, a closely held C corporation is a C corporation that at any time during the last half of the tax year is owned more than 50% in value (directly or indirectly) by five or fewer individuals. Also, the corporation must not qualify as a PSC. A PSC is a C corporation that satisfies a principal-activity test (i.e., rendering of personal services in certain fields), a substantial-performance-by-employee-owners test, and an ownership test (see Secs. 469(j)(2) and 269A(b) for the definition of a PSC).
Example 3. Shifting Passive Activity Losses to a Closely-held Corporation
John owns a 50% interest in a general partnership that owns a 20-unit apartment complex. John’s share of the partnership’s rental loss is about $50,000 a year. He actively participates in the management of the property. John has no other passive income or losses.
John also owns 100% of Creative Consulting Co. John is a full-time employee of Creative Consulting Co., which operates as a C corporation. In the current year, John anticipates having a personal AGI of $200,000 ($175,000 salary and $25,000 interest and dividend income). Creative Consulting Co. will have current-year net income of approximately $250,000.
John is unable to benefit from the special $25,000 rental real estate loss allowance since his modified AGI exceeds the phaseout threshold. This situation is likely to continue in the future, so the losses from the apartment complex will be suspended under the PAL rules.
In this situation, John might find it advantageous to contribute his partnership interest in the apartment complex to Creative Consulting Co., using a Sec. 351 tax-free exchange.
Sec. 351 allows a tax-free incorporation transfer if certain requirements are met, including that the property must be transferred to a corporation by one or more persons in exchange for stock in the corporation, and, immediately after the exchange, the transferor(s) is (are) in control (as defined in Sec. 368(c)) of the corporation.
Although the corporation is closely held and subject to the PAL rules, it can offset net active income with passive losses. This enables the passive losses to be deducted currently.
If John has any suspended losses at the time the transfer is made, they remain suspended since a Sec. 351 transfer is not a taxable transaction. He can utilize the suspended losses against any future passive income he generates or deduct them when the corporation disposes of the partnership interest to an unrelated party.
If John was not already a shareholder in a C corporation, John could evaluate his need for a C corporation, set one up and proceed with the transfer if facts of his unique situation made this move attractive.
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