If You Want to Rely on a Lease for Tax Purposes You Need to Follow It

Originally Published on forbes.com on February 14th,2012

______________________________________

Nobody is going to care about this case , but I have to write about it anyway.  The Passive Activity Loss Rules (Code Section 469) require us to put our trade or business activities into buckets.  If the activities in the passive bucket net to a loss, that loss is suspended and carried forward until there is net passive income in the future or one of the activities is fully disposed of.  One way of dealing with this is to figure out how to get an activity out of the passive bucket, perhaps by spending more time on it.  In the case of limited partnerships or per se passive rental activities, that is not an option.  If you can’t lower the river, maybe you can raise the bridge.  How about converting some of your non-passive income to passive income ?  You are a doctorpracticing in an S corp, which rents its office from you.  Rental activities are per se passive.  So raise the rent and take a lower salary.  The losses from the chinchilla farm can now be used since you have positive passive incomefrom renting to your own medical practice.

This idea runs smack into Reilly’s First Law of Tax Planning – Anything easy to think of probably has a rule against it.  There are a variety of things that under the regualtions  produce passive losses, but to the extent they are profitable have some of their income recharacterized so they do not produce passive income.  Included among these “heads we win, tails you lose propostitions” is renting property to a business you own. When that rule went into effect, there was transtional relief for existing leases:

To qualify for transitional relief under the regulation, a taxpayer must prove that the rental income in question was paid pursuant to a written lease that was entered into before February 19, 1988, and was still in effect

At Joseph B. Cohan and Associates, we had a “medical department” (mostlydentists actually).  The Tax Reform Act of 1986 was a shock to our systems for a variety of reasons.  The effect of the passive activity loss rules was not the least of those shocks.  The rental recharacteriztion rule was one of those subtleties that could slide by in the early transition years if someobody bookish, introverted and compulsive did not look at the return.  Before long there was a ready made answer to jerks like me who raised the issue- “There is a pre ’87 lease in effect”.  That got us through the nineties, but as people started worrying about planes dropping form the sky because their software was written in COBOL and would get confused by the turn of the century, I started to get more and more skeptical about how many pre-1987 leases really were in effect. 

Ramesh Sarva the CPA for Dr. L.A. Samarasinghe did not develop skepticism about the 1980 leases between the doctor and his corporation, for a good reason.  It seems that Mr. Sarva’s services went a little beyond what I think CPAs are supposed to be doing:

After petitioners purchased the Westwood property, Mr. Sarva prepared a lease using a standardized lease form that purported to lease the Westwood property to the medical corporation in exchange for monthly rent paymentsand other consideration. The lease recited that the medical corporation would use the Westwood property as a doctor’s office. The lease ran from July 1, 1980, until June 30, 1981, with the term “to be renewed automatically unless sooner terminated as hereinafter provided, at the ANNUAL RENT of $30,000.00 with 5% increase every year all payable in equal monthly installments in advance on the first day of each and every calendar month.

I’m paranoid about being accused of practicing law without a license so I would not draw up a lease for one of my clients.  Maybe things are different in New Jersey or maybe I am too conservative.  Regardless, Mr. Sarva could be confident there was a lease.  Since it was entered into well before the Tax Reform Act of 1986, the doctors profits from leasing property to his medical corporation are treated as passive income allowing him to deduct losses from God knows what.  It actually might have worked.  Why did it fail ?  Poor execution:

 At the end of the fiscal year Mr. Sarva made adjusting entries which allocated the payments made to petitioner during the year to specific expense accounts, such as salary/payroll and rent. Mr. Sarva determined the amounts to be allocated to salary and to rent. In making the allocation to rent, Mr. Sarva did not consult the 1980 lease, and he assumed that the annual rental period coincided with the medical corporation’s fiscal year. With respect to the fiscal years ending November 30, 2005 and 2007, Mr. Sarva did not calculate what the annual rent should be under the 1980 lease, assuming it was in effect for those years, nor did he determine the amount of the required monthly lease payment under the lease. The record contains no evidence that the medical corporation made monthly rent payments to petitioners during 2005 and 2007 as would have been required by the 1980 lease, assuming that the lease was still in effect for those years.

The Tax Court noted that the taxpayer had gone a long way toward meeting the exception:

Petitioners executed a written lease with respect to the Westwood property—the 1980 lease. Because the parties do not dispute that the lease was entered into before February 19, 1988, and was in writing, the sole issue remaining is whether the 1980 lease remained in force and was binding under State law for 2005 and 2007. We examine relevant State law and the actions of the parties to the 1980 lease during the years at issue to decide this issue. The parties agree that the relevant State law is the law of the State of New Jersey.

The parties do not appear to dispute that the 1980 lease was a binding contract that was enforceable under State law when it was originally executed in 1980. The parties’ disagreement focuses on whether the 1980 lease was still a binding contract with respect to the years 2005 and 2007. Under New Jersey law, parties to a contract may modify, abandon, abrogate, or rescind a contract.

The Court concluded that however binding the lease was in 1980, by 2004 it was just a piece of paper:

The record overwhelmingly demonstrates that, during the taxable years ending in 2004 through 2009, the 1980 lease was a meaningless document that was simply not followed by petitioners, the medical corporation, or Mr. Sarva, who implemented and supervised the rental arrangement.

 On the bright side there penalties were not assessed since reliance on Mr. Sarva was reasonable:

Mr. Sarva has been a practicing C.P.A. for over 30 years. He has extensive experience in tax planning and return preparation and has advised clients with respect to real estate transactions.  Petitioners relied on Mr. Sarva’s judgment in purchasing the Woodside property in 1979, in setting up the leasing transaction, and in preparing their and the medical corporation’s tax returns each year. Given Mr. Sarva’s credentials and the longstanding professional relationship between petitioners and Mr. Sarva, we find that petitioners were justified in relying on Mr. Sarva.

Having been practicing myself for over 30 years the lesson I take from this is one that I find particularly apt in the family limited partnership area but that has broader applicability.  Almost nobody thinks an accountant’s  journal entries mean anything other than other accountants.  If the medical corporation has a lease that says it is supposed to pay rent every month, have it cut a check for rent in the correct amount for rent every month.  Execute the transactions in accordance with the agreements.  I should probably make that my Second Law of Tax Planning.

 You can follow me on twitter @peterreillycpa.