Farris v. Commissioner of The Internal Revenue, T.C. Summary Opinion 2007-192 (U.S.T.C. 11/13/2007)
| Decision Date | 13 November 2007 |
| Docket Number | No. 4631-06S.,4631-06S. |
| Parties | GREGORY J. FARRIS, Petitioner v. COMMISSIONER OF THE INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
This case for the redetermination of deficiencies was heard pursuant to the provisions of section 7463.1 Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court and this opinion shall not be treated as precedent for any other case.
Respondent determined deficiencies of $13,259, $17,251, and $17,482 in petitioner's Federal income tax for 2000, 2001, and 2002, respectively. The issue for decision for each year is whether petitioner understated his passive activity loss.2 The resolution of the issue depends upon whether rental income petitioner received from his closely held corporation is properly characterized as passive so as to offset passive losses incurred during the year, as petitioner claims, or whether the rental income is nonpassive, as respondent determined.
Substantially all of the facts have been stipulated and the stipulated facts are so found. At the time the petition was filed, petitioner resided in Gardiner, Maine.
On or about May 14, 1985, petitioner and Mark E. Susi (Susi), both practicing attorneys, formed Farris & Susi, R.E. (the real estate partnership), for purposes of buying, selling, and renting real estate. In the same year, the real estate partnership acquired property located at 251 Water Street, Gardiner, Maine (the Gardiner property), which consisted of three commercial buildings.
Under a lease agreement (the 1985 lease), the real estate partnership rented the Gardiner property to Farris & Susi, a Maine partnership (the law partnership) then consisting of two partners; namely, petitioner and Susi. The law offices of the law partnership were located at the Gardiner property. The 1985 lease remained in effect at least until December 31, 1989.
In early 1987, a flood at the Gardiner property caused a significant disruption to the law partnership's practice and the loss of numerous documents, including, more likely than not, the 1985 lease.
On or about January 1, 1990, the real estate partnership, as the lessor, and the law partnership, as the lessee, entered into a written lease (the 1990 lease) for the Gardiner property. The 1990 lease was signed by petitioner on behalf of the real estate partnership and by Susi on behalf of the law partnership.
At some point afterwards, petitioner and Susi admitted new partners to the law partnership. Towards the end of 1992, petitioner and Susi were practicing law as partners in Farris, Susi, Heselton, & Ladd, P.A. Subsequently, on or about December 30, 1992, Farris, Susi, Heselton, & Ladd, P.A., was incorporated as a Maine corporation (the corporation). The change in legal form and structure of the law practice was prompted in part by malpractice insurance concerns as well as by the addition of new attorneys. Around the same time, the real estate partnership, as lessor, entered into a new written lease with the corporation, as the lessee, for the Gardiner property (the 1992 lease). In January 2000, Susi sold his partnership interest in the real estate partnership to petitioner. As a result, petitioner became the sole owner of the Gardiner property. Around the same time, petitioner, as lessor, entered into a new lease for the property with the corporation as lessee (the 2000 lease). The corporation later changed its name to Farris, Heselton, Ladd, & Bobrowiecki, P.A.
During 2000, 2001, and 2002, petitioner was the majority shareholder in the corporation, which was the source of all of his income from the practice of law during those years.
On his 2000, 2001, and 2002 Federal income tax returns, petitioner reported net passive income from renting the property to the corporation of $34,839, $46,168, and $48,391, respectively. For each year, the net passive income was entirely offset by passive losses attributable to other real estate that petitioner owned and held for rent during those years.3
In the notice of deficiency respondent increased petitioner's income for each year by the appropriate amount of the rental income shown above. According to the explanation in the notice of deficiency, because the "rental income is from a rental to a corporation in which * * * [petitioner] materially [participates], the income from that activity is considered non-passive." Therefore, according to respondent, the nonpassive rental income, obviously otherwise includable in petitioner's income, cannot be offset by petitioner's passive losses. Other adjustments made in the notice of deficiency are not in dispute and need not be addressed.
Section 469 generally disallows for the taxable year any passive activity loss. Sec. 469(a)(1). The term "passive activity loss" is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. Sec. 469(d)(1). A "passive activity" is "any activity * * * which involves the conduct of any trade or business, and * * * in which the taxpayer does not materially participate." Sec. 469(c)(1). The term "passive activity" generally includes any rental activity regardless of whether the taxpayer materially participates. Sec. 469(c)(2), (4).
While the general rule of section 469(c)(2) characterizes all rental activity as passive, section 1.469-2(f)(6), Income Tax Regs., requires net rental income received by the taxpayer for use of an item of the taxpayer's property in a business activity in which the taxpayer materially participates to be treated as income not from a passive activity; this is sometimes referred to as the "self-rental rule" or the "recharacterization rule". Sec. 469(c)(2); sec. 1.469-2(f)(6)(i), Income Tax Regs. In relevant part, that regulation provides as follows:
(f)(6) Property rented to a nonpassive activity. 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 * * * in which the taxpayer materially participates (within the meaning of § 1.469-5T) * * * for the taxable year.
Simply put, the regulation recharacterizes a taxpayer's rental income from property rented for use in a trade or business in which the taxpayer materially participates as nonpassive income and therefore not taken into account in the computation of the taxpayer's passive activity loss.
A transition rule, however, allows for an exception to the recharacterization rule. The transition rule provides that:
In applying * * * [the recharacterization rule] to a taxpayer's rental of an item of property, the taxpayer's net rental activity income * * * from the property for any taxable year beginning after December 31, 1987, does not include the portion of the income (if any) that is attributable to the rental of that item of property pursuant to a written binding contract entered into before February 19, 1988. [Sec. 1.469-11(c)(1)(ii), Income Tax Regs.]
Petitioner concedes that he "materially participated" in the conduct of the corporation during 2000, 2001, and 2002. Furthermore, he acknowledges the application and validity of section 1.469-2(f)(6), Income Tax Regs.4 He takes the position, however, that he is entitled to relief from the consequences of the recharacterization rule by virtue of the transitional rule referenced above.
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