Can Owners of Real Estate Create Passive Income From Themselves to Help Offset Limited Passive Losses Elsewhere?

Can owners of real estate create passive income from themselves to help offset limited passive losses elsewhere? This question actually comes up quite frequently and arises typically after a taxpayer has already started down the road in an attempt to achieve a tax deduction. The bad news is that in a nutshell, the answer is most often, no. Let’s illustrate via a typical example:

Mr. X and Mrs. X own a warehouse, individually, that is used by XYZ Distribution Company, which they also own and are actively involved in operations. XYZ pays rent to Mr. and Mrs. X. Since Mr. and Mrs. X have quite a bit of income being generated by the distribution company, they have implemented a lease that is on the high-end of the reasonable lease requirement. Mr. and Mrs. X also own an apartment complex, that, due to a cost segregation study, has been producing some substantial deductions. Thus, their plan is to use the deductions from their passive investment in the apartment complex to offset their rental income from the distribution company. Sounds like a great plan. They are working around the premise that the only income that offsets passive losses is passive income (or at least they thought they were).

Thus, Mr. and Mrs. X have generated as much passive income from the distribution company as they can, in order to fully utilize the deductions generated from depreciation after paying for a cost segregation study. However, the IRS has issued a regulation, Reg 1.469-2 to prevent owners from possibly inflating their “passive” income to use to offset “normal” passive losses. If you read all the way down to the bottom to arrive at 1.469-2(f)(6)(i), you will note that income is “not from a passive activity if the property is rented for use in a trade or business activity in which the taxpayer materially participates…”.Thus, since Mr. and Mrs. X are actively involved in XYZ, any rent received from that company would not be characterized as passive income. This regulation was enacted to prevent owners who have self-rental property from controlling their amount of passive income. This rule results in “self-generated rental income” to be recharacterized as “non-passive”, which prevents it from netting with passive losses. Thus, in Mr. and Mrs. X case, they will have to recognize the income from the rentals by XYZ, but they will not be able to enjoy the deductions from depreciation of the apartment complex (unless other facts would allow). Since the investment in the apartment complex is a passive investment for Mr. and Mrs. X, they have not fared very well by undertaking a cost segregation study.The key here is to be sure to consult your real estate tax advisor before implementing a tax strategy with multiple activities to ensure it will produce the results you are seeking.