Disallowed loss from depreciation on self-rental

We have an S-corp auto dealership client (call it Dealership 1) that owns the property of an adjacent affiliated dealership (call it Dealership 2). This dealership rents the property to the other dealership, thus creating a self-rental situation.

Dealership 1 prepared Form 8825 (using code 7 for self-rental) to report the self-rental income from Dealership 2 in 2011 (which we did not prepare). Dealership 1 had a cost segregation study performed and reported depreciation expense for the Dealership 2 property on Form 8825 on Dealership 1's return. This created a loss on Form 8825 of roughly $800K. This loss was netted against the other nonpassive income on the shareholders' personal returns.

The IRS is challenging the deduction of this loss this by asserting that the loss remains passive due to the self-rental rules. My argument is that although the loss was generated from a self-rented property, the property is used by an affiliated operating company itself and the depreciation is attributed to a nonpassive activity. Personally, I think the depreciation should have been reported on page 1 of the return, rather than on Form 8825, as it is distinguishable from the rental activity.

Am I on track here or have we fallen into the self-rental trap?

It'd be nice to know who owns what here, in terms of the stock.

I think you're in a self rental trap.

What you needed was a grouping of rental and nonrental businesses that constituted an appropriate economic unit.

But that may be difficult depending on the location and as Chris said ownership.

Dealership 1 = 50% Joe's living trust, 25% Joe's wife, 25% Bob's living trust

Dealership 2 = 50% Bob's living trust, 50% Joe's wife's living trust

Joe and Bob are brothers.

As usual Chris is couple of steps ahead. adjacent would do okay for location, similarity of business is good, ownership or common control could be an issue.

Then you also have to beg for reasonable cause, or whatever strong reasonable cause argument you have for allowing a late grouping election. Good luck.

ownership looks good.

see that late election relief.

I'll see if that late election relief is possible, especially since this is an audit situation.

But how exactly have we created a passive rental loss from depreciation? The dealership property is used in an active trade or business and the depreciation would be reported as a deduction against nonpassive activity if it were owned by Dealership 2 and reported on those books. The self rental rule is supposed to be designed to prevent the abuse of passive loss rules by artificially adjusting rent. The depreciation is clearly a separate animal.

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I'll see if that late election relief is possible, especially since this is an audit situation.

But how exactly have we created a passive rental loss from depreciation? The dealership property is used in an active trade or business and the depreciation would be reported as a deduction against nonpassive activity if it were owned by Dealership 2 and reported on those books. The self rental rule is supposed to be designed to prevent the abuse of passive loss rules by artificially adjusting rent. The depreciation is clearly a separate animal.

Taxpayer's are allowed to choose their business entity structures and are bound by the results thereof.

and the depreciation would be reported as a deduction against non-passive activity if it were owned by Dealership 2

"if"

...but we need to think about how the self-rent applies (here), that's one reason I asked about ownership. Normally, it's a simple situation of an individual owning the real estate and the individual's wholly-owned S-corp or C-corp paying rent. Here, we have one entity paying rent to another entity.

The self-rental rule of Treas. Reg. §1.469-2(f)(6) creates an exception to the IRC §469(c)(2) rule that any rental activity is automatically treated as a passive activity. The regulation provides that net rental income received by a taxpayer for use of an item of the taxpayer’s property in a business in which the taxpayer materially participates shall be treated as income not from a passive activity. In other words, the self-rental rule reclassifies the net rental income as non-passive income.

The self-rental rule applies only to net rental income. It doesn’t apply to a net rental loss. As a result, the $800K loss that resulted from Dealership 1 renting the property to Dealership 2 is a passive loss.

I don’t understand your argument about the depreciation being a “separate animal” and not part of the net rental loss. Depreciation is clearly a rental deduction that must be included in calculating the net rental income or loss. The depreciation you're referring to is the depreciation of the property being rented, right? How could it be a "separate animal"?

The depreciation you're referring to is the depreciation of the property being rented, right?

He's basically invoking a grouping argument, which is where you end up if the lessee entity owned the property outright. In other words, instead of a lease arrangement, had the lessee entity owned the property and paid no rent, the depreciation deduction would just be a regular old Sec 162 deduction to the "lessee" entity.

I agree that either the IRS agent mis-uses the self-rent rule, or maybe Green mis-understood something. That doesn't matter much, however, since IRS is saying the loss is passive.

Terry made some comments about grouping. I asked about ownership for a few reasons, one of which was to ascertain common ownership. We might be able to put forth an argument that the individual taxpayer already grouped these activities, as evidenced by the manner in which they were reported on his Schedule E, Page 2. Remember: The formal written designation of your groups is pretty recent tax law. Prior to this law, no written grouping elections were required. And, existing groups were grandfathered.

I'm not sure how long these dealerships have been leasing property from one another...but if it's been awhile, we might be okay on this.

By replying "if," Ckenefick noted correctly that GreenCPA is making a hypothetical argument by saying, "the depreciation would be reported as a deduction against nonpassive activity if it were owned by Dealership 2." You must deal with the facts as they are and not make a hypothetical argument that the taxpayer could have set it up differently.

As for grouping, the regulations place a major restriction on grouping a rental activity with a business activity. Treas. Reg. §1.469-4(d)(1)(i) provides that you may not group a rental activity with a business activity unless they constitute an “appropriate economic unit” and either (1) the rental activity is insubstantial in relation to the business activity, or (2) the business activity is insubstantial in relation to the rental activity, or (3) each owner of the business activity has the same proportionate ownership interest in the rental activity. I don't see that (1), (2) or (3) exist here.

Yes, I think we need to focus more closely on the grouping aspect. We might be out of luck, but I think that's where the answer lies.

Yes, I agree. For example, suppose we focus on Treas. Reg. §1.469-4(d)(1)(I)(C) (the third element listed in my message). Here's how this regulation reads:

(C) Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

Assuming that Dealership 2 is also a corporation, IRC §267(c)(2), which is part of the constructive stock ownership rules, provides that for purpose of the related party rules, an individual shall be considered as owning the stock that is owned by or for his family. As a result, since all of the owners of both corporations are members of the same family (Joe, Joe's wife, Bob, who is Joe's brother), could we argue that the owners, together, have the same proportionate ownership interest in both Dealership 1 and Dealership 2? I know it's a stretch because the individual ownership percentages are different between the two dealerships, but will such an argument fly? If it does, then grouping is permitted. And as Terry pointed out, a late grouping election is allowed. I believe the late grouping election is allowed under Treas. Reg. §1.469–11(b)(3)(iv).

Thank you for the input. It seems that a request for a late grouping election is the way to go. We would have to establish reasonable cause, as the Service discovered the "failure to disclose".

I think reasonable cause can be established. This unit has been renting out the property for what I believe is far longer than the requirement to make a written election on the return. Also, the one-time depreciation deduction item does not appear to be a deliberate attempt to circumvent the rules of Sec. 469.

It seems that a request for a late grouping election is the way to go. We would have to establish reasonable cause, as the Service discovered the "failure to disclose".

First, what leads you to believe that client hasn't already made a grouping election? You haven't given us any timeline here as to when the rental arrangement began, how it's historically been reported on the 1040 and whether or not the cost seg study was performed when the rental arrangement began or at some later date. You do say it's a depreciation deduction, but I'm wondering if it's a 481 adjustment.

Second, how do you even know that this activity can be grouped in the first place? See Dave's comments about substantiality and proportionate ownership.

Also, the one-time depreciation deduction item does not appear to be a deliberate attempt to circumvent the rules of Sec. 469.

Not relevant.

It seems that a request for a late grouping election is the way to go. We would have to establish reasonable cause, as the Service discovered the "failure to disclose".

First, what leads you to believe that client hasn't already made a grouping election? You haven't given us any timeline here as to when the rental arrangement began, how it's historically been reported on the 1040 and whether or not the cost seg study was performed when the rental arrangement began or at some later date. You do say it's a depreciation deduction, but I'm wondering if it's a 481 adjustment.

Looks like the rental arrangement started in 2010, so that may change things. As far as my knowledge, the cost seg was performed after the rental arrangement began. I would think that, yes, the catch up depreciation would have been treated as a 481(a) adjustment.

Second, how do you even know that this activity can be grouped in the first place? See Dave's comments about substantiality and proportionate ownership.

I don't. This will have to be argued. The ownership presents problems as it isn't exactly proportionate.