Passive Loss Self-Rental Regulation Was Valid: 5th Cir. Affirms DC.

• Author: Fiore, Nicholas J.

During 1995, F owned an undivided half interest in a building. He leased that building to his wholly owned law firm, which was organized as a C corporation.

On his 1995 return, F treated the rental income as passive activity income. He also had substantial, unrelated passive activity losses (PALs). Because Sec. 469 allows deductions for PALs up to the amount of passive activity income, F deducted this income against the PALs.

The IRS rejected this treatment, arguing that it was invalid under Regs. Sec. 1.469-2(f)(6). F challenged the validity of this regulation. The district court held for the Service and the Court of Appeals (opinion Higginbotham, J.) affirms.

Regs. Sec. 1.469-2(f)(6), called the "serf-rental rule," provides as follows:

An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property--(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of [sections] 1.469-5T) for the taxable year; and (ii) Is not described in [sections] 1.469-2T(f)(5).

In essence, the regulation provides that when a taxpayer rents property to his own business, the income is not passive activity income.

The regulation stems from Sec. 469. Sec. 469(c) sets forth provisions that define passive activity as including rental activity. Sec. 469(1)(3), however, authorizes the Service to promulgate regulations that treat a passive activity as nonpassive.

Here, the parties dispute the scope of passive activity the IRS may treat as nonpassive. The point of uncertainty lies with the word "other" in Sec. 469(1)(3). F suggests that "other" refers to activity not elsewhere defined in Sec. 469 as passive. However, the more persuasive reading of the provision is that a regulation may treat any kind of passive activity as nonpassive. In the provision, "or other" appears to refer back to "limited partnership" and thus to include any passive activity other than a limited partnership.

The legislative history supports this view: it provides examples of situations in which the...