Avoiding Recharacterization of Rental Income on Resale of
Self-Developed Property

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 15th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8724; www.ppcnet.com).

Facts: David Turner is a 50% general partner in Turner Development Partnership, which develops commercial real estate. In early 1992, the partnership acquired three acres of land for development, on which it constructed a building that was ready for occupancy on Oct. 1, 2001. The first tenants moved in on that same date. By the end of 2001, the building had 60% occupancy. On May 1, 2002, a potential purchaser offered to buy the land and the building. At that time, the building had 80% occupancy. The building was not held for sale to customers in the ordinary course of Turner Development Partnership's trade or business. If the sale were finalized, David would realize a $100,000 gain. • David's distributive share of the taxable loss from rental of the building during 2001 and 2002 was $60,000 and $30,000, respectively. David materially participated in the partnership's operations during both years, overseeing construction and leasing. Turner Development had no other properties during 2001 and 2002, and David's 2001 adjusted gross income (AGI) was $170,000. David does not meet the requirements for a real estate professional. • He wants to use the gain on the sale of the building to offset passive activity losses (PALs). Issues: How should David treat the 2001 rental losses? How should he structure the sale of the land and building to ensure that the gain will be passive income?

Analysis

The 2001 $60,000 loss is a passive loss from a rental activity that David can offset against other passive income (if he has any). Because David owns more than 10% of the activity and is a significant participant, he would be eligible to treat a portion of the loss under the $25,000 offset for rental real estate activities if his AGI is below $150,000. However, because David's 2001 AGI is $170,000, he cannot offset any of the rental loss. If David wants to treat the gain on sale of the building as passive, he will need to structure the sale to avoid the recharacterization rules. If the property were sold within 12 months of the date on which it first was made available for lease, the sale would clearly satisfy the recharacterization provisions. David would recharacterize the net rental income from the property as active income if such income were positive. For 2002, the net rental activity income is $10,000 ($100,000 – ($60,000 + $30,000)). Thus, $10,000 of David's gross rental activity income from the partnership is active income in 2002. Assuming no depreciation recapture, the $10,000 is Sec. 1231 gain.

After the passive netting process is complete, David has $90,000 of ordinary loss and $90,000 of Sec. 1231 gain that comes out from under the passive umbrella (as the sale was a complete disposition of a passive activity).

If the property were sold 12 months or more after the commencement of use, the recharacterization provision will not apply. Thus, David would treat the net rental activity income of $10,000 as passive income. This is available to absorb other passive losses that David might have.

If David wants to ensure the passive character of the gain on the sale, he should schedule the sale's closing date more than 12 months after the date on which the use of property begins.

In November 1990, Treasury amended Temp. Regs. Sec. 1.469-2T(f)(5) to provide rules governing when use of property begins. Under these rules, David is deemed first to use the property on the earlier of the date:

1. He acquired an interest in the property.

2. Substantially all of the property was first held out for rent or was in a state of readiness for rental.

3. No significant value-enhancing services (other than lease-up) remained to be performed.

For Turner Development, the earliest of these dates is Oct. 1, 2001 (the date on which the building was ready for occupancy). Therefore, the "use" of the building is deemed to begin on that date. If the property were sold on May 1, 2002, for example, only seven months would have elapsed since the "commencement of use" date. The partnership would have to hold the building at least five additional months to ensure that David's gain on the sale will be passive.

Conclusion

David's 2001 $60,000 loss is a passive rental loss that he can offset only by other passive income. (David does not qualify for the special $25,000 rental-real-estate exception.) The character of David's gain on the sale of the building depends on how long he holds the building after "use" of the building commences. If he sells the building more than 12 months after the commencement of use, he could not recharacterize the $10,000 of net rental income ($100,000 – ($60,000 + $30,000)) as active income. It will retain its passive character; if he holds the building for 12 months or less after use commences, his net income will be active.

Variation

What if the sale date was less than 12 months after commencement of use and the gain was only $85,000? The recharacterization rules do not apply, as there is no net rental activity income. The $85,000 is gain from the disposition of a rental activity, rather than gain from the development activity. Accordingly, David can apply the $85,000 to a portion of the $90,000 PAL. He can deduct the $5,000 net loss from the project in the year of sale, assuming he retains no other interest in the activity.