Taxpayers Beware! Fifth Circuit Appellate Court Applies the "Self-Rental Rule" to Preclude Taxpayers from Applying Passive Loss Against Rental Income

Earlier this month, the Fifth Circuit Court of Appeals had occasion to decide the applicability of the “self-rental rule” in Treas. Reg. § 1.469-2(f)(6) in the context of a Subchapter S corporation renting commercial real estate to its affiliated Subchapter C corporation. See Williams v. Comm’r, 2016 BL 28240, 117 AFTR 2d ¶ 2016-393 (5^th Cir. 2016). The court’s decision is notable because the Fifth Circuit essentially ignored the S corporation’s involvement in the transaction in applying the “self-rental rule.” According to the Fifth Circuit’s decision, a taxpayer will have active rental income that will not be available to offset passive losses in the situation in which: (i) the taxpayer has an allocable share of rental income from an S corporation’s leasing of the use of property to an affiliated entity; (ii) that affiliated entity uses the leased property in conducting its trade or business activity; and (iii) the taxpayer (but not the S corporation) materially participates in that trade or business activity.

The Self-Rental Rule

A taxpayer’s passive losses can be deducted only to the extent of the amount of that taxpayer’s passive activity income. See I.R.C. § 469(a), (d). Any excess amount of passive activity losses is suspended and carried forward to the subsequent year. See I.R.C. § 469(b). Rental activities are generally considered as giving rise to passive income or loss. See I.R.C. § 469(c)(2). Congress explicitly authorized the Treasury Secretary to promulgate regulations requiring net income or gain from a passive activity to be treated as not from a passive activity. See I.R.C. § 469(l).

The Treasury Department exercised that authority by promulgating the “self-rental rule” in Treas. Reg. § 1.469-2(f)(6). This rule basically provides that that an amount of the taxpayer’s net rental activity income for the taxable year from an item of property is treated as not from a passive activity if that property is rented for use in a trade or business activity in which the taxpayer materially participates. See id.  

The Dispute in Williams v. Comm’r

In Williams, the taxpayer was an individual who, together with his wife, owned 100% of two companies: (i) BEK Real Estate Holdings, LLC (“BEK Rental”), a Subchapter S corporation; and (ii) BEK Medical, Inc. (“BEK Medical”), a Subchapter C corporation. Williams worked full time for, and had material participation in the activities of, BEK Medical. Williams, however, did not have material participation in the activities of BEK Rental and did not conduct any other rental activity.

For 2009 and 2010, Williams reported net rental income from BEK Rental’s activities, and Williams offset that net rental activity with passive losses from his other S corporations, partnerships and personally owned rental properties. The IRS determined, however, that Williams’ rental income from BEK Rental was active income that could not be offset by his passive losses from other activities.

Williams challenged the IRS’s determination primarily by arguing that the “self-rental rule” was inapplicable in his circumstance because BEK Rental did not have material participation in the activities of BEK Medical. Thus, Williams read the “self-rental rule” as providing that BEK Rental, the S corporation actually renting the property and deriving the rental income, would be treated as the “taxpayer” for purposes of determining whether there was material participation in the activities of BEK Medical. According to Williams, since BEK Rental did not have material participation in the BEK Medical’s activities, the “self-rental rule” did not apply, and BEK Rental’s rental income was therefore passive income that could be offset by passive losses from other activities. The Tax Court disagreed with Williams’ interpretation of the regulatory language, so he appealed.

The Fifth Circuit’s Decision

The Fifth Circuit also disagreed with Williams’ interpretation of the “self-rental rule.” The Fifth Circuit noted that BEK Rental was an S corporation that did not pay federal income tax and instead passed through its income to Williams, who reported and paid tax on that income. Thus, the Fifth Circuit concluded that BEK Rental was not the “taxpayer” referenced in the “self-rental rule;” instead, Williams was the “taxpayer” for purposes of the rule. Under the Fifth Circuit’s interpretation, BEK Rental leased its property for use in BEK Medical’s trade or business activity in which Williams materially participated. The “self-rental rule” therefore controlled the outcome of the taxpayer’s case, and the rental income derived from BEK Rental’s activities was active income that could not be offset by Williams’ passive losses from other activities.

Significance

Under the “self-rental rule,” a taxpayer who rents property for use in a trade or business in which he/she materially participates will derive active rental income that will not be available for offset by passive losses. The Williams decision shows that the aforementioned result is not changed by interposing a flow-through entity, such as an S corporation or partnership, into the rental transaction.