There is a new tax law that will benefit business owners who have related ownership interests with real estate activity. The change involves the passive activity rules on gains and losses. A company is now permitted to group activity income with related rental income or loss. The ideal facts and circumstances are in situations where the rental property reports a loss that could be deducted against the business income. Taxpayers may use reasonable methods as long as the business and the real estate rental activity involve an appropriate economic unit.
The IRS definition of an appropriate economic unit is as follows: Similar type businesses, have common control, common ownership, geographically local, and activities are interdependent. Interdependence examples include buying and selling goods or services between entities, goods or services provided together, entities having the same customers or employees, and entities use the same set of records to account for the related activities.
With the general guidelines of an appropriate economic unit, the business can group using a reasonable method with the following factors: make sure the business and the real estate are similar in activity; there is common control of the business and real estate; there is common ownership and geographical location; and there is interdependence between the business and the real estate activities.
The grouping can be with two or more businesses, two or more rental activities, or a grouping of a business and a rental. Please be aware that a business can combine the business activity with the rental activity only when one activity is insubstantial in relation to the other activity, or each owner of the business activity has the same proportionate ownership interest in the rental activity.
Unfortunately, the new tax rules do not define insubstantial for determining when a business and a rental can be grouped. In prior tax regulations, the definition gave guidelines that a rental activity's gross receipts would need to be fewer than 20 percent of the gross receipts of the other activity, or vice versa. This test does not apply now.
There have been three court cases that addressed the insubstantial definition with full allowance of the taxpayer's grouping position. The cases allow grouping when the rental property is leased to the business activity and where the gross receipts of one activity (many times the rental) are insubstantial (generally under 10 percent) compared to the other activity.
The new law change requires that taxpayers report a written statement of the grouping for the 2011 and future years. The grouping can add new activities that reasonably can be proven to be appropriate economic units, and the groupings can be regrouped for past errors or change in facts. One needs to consider the facts and circumstances for determining whether this law change is an appropriate tax plan for their individual tax situation. Please seek the advice of your tax advisor for further information and guidance.
Scott T. Wait, CPA, is a shareholder in RS Wait of Reno. Contact him at 825-7337 or scott@rswait.com.
