Friday, March 28, 2014

The U.S. Tax Court holds that a trust holding rental real estate properties qualifies for the section 469(c)(7) passive activity exception.




The passive loss rules operate by requiring taxpayers to classify their income and losses into various categories. Then the rules limit the extent to which losses in the passive category can be used to offset income in the other categories.
The passive loss rules require income and losses to be classified into one of three categories: active, passive, or portfolio.
Active income includes the following:
·       Wages, salary, commissions, bonuses, and other payments for services rendered by the taxpayer.
·       Profit from a trade or business in which the taxpayer is a material participant.
·       Gain on the sale or other disposition of assets used in an active trade or business.
·       Income from intangible property if the taxpayer's personal efforts significantly contributed to the creation of the property.
Portfolio includes the following:
·       Interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business.
·       Gain or loss from the disposition of property that produces portfolio income or is held for investment purposes.
Section 469 provides that income or loss from the following activities is treated as passive:
·       Any trade or business or income-producing activity in which the taxpayer does not materially participate.
·       Subject to certain exceptions, all rental activities, whether the taxpayer materially participates or not.
Although the Code defines rental activities as passive activities, several exceptions allow losses from certain real estate rental activities to offset nonpassive (active or portfolio) income.
Section 469 specifies that the following types of activities are to be treated as passive:
·       Any trade or business or income-producing activity in which the taxpayer does not materially participate.
·       Subject to certain exceptions, all rental activities.

Material Participation in a Real Property Rental Trade or Business

An exception to the general rule relates to a special rule for material participation in a real estate rental trade or business. Losses from real estate rental activities are not treated as passive losses for certain real estate professionals. To qualify for nonpassive treatment, a taxpayer must satisfy both of the following requirements:
·       More than half of the personal services that the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates.
·       The taxpayer performs more than 750 hours of services in these real property trades or businesses as a material participant.
Taxpayers who do not satisfy the above requirements must continue to treat losses from real estate rental activities as passive losses.
Recently on March 27 the U.S. Tax Court held that a trust holding rental real estate properties qualifies for the section 469(c)(7) passive activity exception, because services performed by the trustees are considered personal services performed by the trust and the trust materially participated in the real estate business activities (Frank Aragona Trust et al. v. Commissioner, 142 T.C. No. 9, No. 15392-11 (2014) ).
It has been noted that the case will have important ramifications for section 1411. Section 1411 provides that the 3.8 percent tax will not apply if the trust materially participates in the underlying trade or business. The ultimate conclusion of the case is that the trust materially participated in its rental business.

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