Passive income recharacterization in related-party leases.

• Author: Donovan, James J., III

Temp. Regs. Sec. 1.469-2T(f)(6) provides a net income recharacterization rule that applies to income from property rented for use in an active trade or business in which a taxpayer materially participates. This rule applies only if the lessor is subject to the passive activity rules; the lessee is a pass through entity; the lease was entered into, extended or modified after Feb. 29, 1988; and the lease generates net taxable income. The regulations are intended to prevent the conversion of active trade or business income to passive income by manipulating the lease terms among related entities.

Example 1:0 is the sole shareholder and materially participates in an S corporation that operates a hardware store. He personally owns the building, which he leases to the S corporation at a fair market rate. Conceptually, all the income generated by this activity should be active business income to O. Without Temp. Regs. Sec. 1.469-2T(f)(6), it is possible to report a portion of this activity as passive income, thereby offsetting other passive losses that O has and correspondingly reducing his otherwise active business income.

The mechanical aspects of this rule become more difficult when multiple entities are involved. The recharacterization must be determined for each activity and for each entity subject to the passive loss rules. Example 2: Partnership ABC consists of three individuals (A, B and C)who own and lease a building to an S corporation in which A and B materially participate. The net rental income must be recharacterized as portfolio income for A and B while the income allocable...