When Is a Rental Property Not a Rental Property?

I n Krutkowski, 114 TC No. 25, the Tax Court concurred with the IRS's determination that rental income received by the sole shareholder of a C corporation from his corporation was nonpassive and could not be offset by other passive losses.

Krutkowski was the sole shareholder of two C corporations. One corporation operated a health club; the other operated a law firm for which Krutkowski worked as an attorney. Krutkowski materially participated in the law firm, but not in the health club. Krutkowski realized a loss renting a building to the health club; he realized income renting a building to the law firm.

Krutkowski's income tax return reported both the income and the loss as passive. The Service recharacterized the income as nonpassive under the recharacterization rules of Regs. Sec. 1.469-2(f)(6).

The Tax Court ruled:

• The recharacterization rule is valid.
• State law determines whether a lease is extended or renewed; if renewed, the lease is a new lease and does not qualify under the grandfather rules of Regs. Sec. 1.469-11(c)(1)(ii).
• Regs. Sec. 1.469-11(b)(1) does apply to rentals to a C corporation.

The question is whether the taxpayer could have done anything differently to offset the loss and the income from the two activities.

Krutkowski was the sole shareholder of two C corporations. If he materially participated in the health club, the rental loss would likely be deemed a passive activity loss. Changing the legal entity of the health club or the law firm to an S corporation, limited liability corporation or partnership would also not change the outcome, unless Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(F) applied.

Under Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(F), the definition of a passive activity excludes "property made available for use in a nonrental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest." If a taxpayer owns an interest in a partnership, S corporation or joint venture conducting an activity other than a rental activity and he provides property for use in the activity in his capacity as an owner of an interest in such partnership, S corporation or joint venture, the provision of such property is not a rental activity.

The determination of whether the property used in an activity is provided by the taxpayer in his capacity as an owner is made on the basis of all the facts and circumstances. A taxpayer is making the property available in his capacity as an owner if he contributes the right to use it for zero rental; however, this is not the only exception to the rental rule. Other factors to take into account in determining whether the owner is providing property in his capacity as owner are:

• Is the taxpayer charging a fair market rental?
• Did the owner decline considering other rental customers?
• Was the rental negotiated at arm's length?

If the owner is the 100% owner of the property and 100% owner of the passthrough entity tenant, the likelihood of there being an arm's-length transaction is minimal, and the owner will likely ignore other rental customers.

On discussing the situation of the 100%-owned property with an IRS representative, his interpretation was that, if the taxpayer was charging a less-than-fair-value rental, the rental activity should be split into two components—a rental activity with fair value rent being charged and a nonrental activity providing the property with no rent in his capacity as owner. Determining how the property would be split is difficult; however, taking this interpretation one step further, if the portion of the above activity was a fair value rental, it would likely need to generate a profit. If this activity generates a profit, it would be reclassified as nonpassive per Regs. Sec. 1.469-2(f)(6). The second component would be the activity provided in his capacity as owner with no rent charged; this would also be considered a nonpassive activity, despite the activity being rental property with a realized loss.

The result is that a "rental" activity provided to a 100%-owned passthrough entity that generates a loss will be reclassified as a non-passive activity.

From Robin Kline, CPA, Brown, Dakes & Wannall, P.C., Fairfax, VA