December 2007 Technical Update

Passive losses; NOT always passive

It is quite common for a taxpayer’s business to lease space from a related entity. One common example is when a medical practice leases space from a partnership consisting of the medical practice’s doctors.

In many instances, the losses generated by the rental activity are considered passive losses. However, with proper planning the losses from the rental activity can be considered non-passive and be applied to offset the income of the taxpayer’s business and its individual partners.

Regulation §1.469-4 (Definition of activity) sets forth the rules for grouping a taxpayer's trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of §469. According to this section, one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of §469.

Whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. Some of the factors listed in §469 include:

(i) Similarities and differences in types of trades or businesses;
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographical location; and
(v) Interdependencies between or among the activities.

The grouping of rental activities with other trade or business activities under this section is subject to certain limitations. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and:

(A) The rental activity is insubstantial in relation to the trade or business activity;
(B) The trade or business activity is insubstantial in relation to the rental activity; or
(C) Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

Establishing these losses as non-passive creates tax saving opportunities that did not exist when they were considered passive. For instance, when the losses were considered passive, there might not have been a need to maximize depreciation deductions by using a cost segregation study. However, if the losses are considered non-passive, maximizing the depreciation deductions by having a retroactive cost segregation study performed would offset the income of your client’s business and its individual partners.