Avoiding recharacterization of rental income on resale of self-developed property.

• Author: Ellentuck, Albert B.

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...