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By Kent N. Schneider

Since the enactment of the passive loss rules in 1986, taxpayers have found it difficult to reduce their tax liability through the use of classic tax shelter investments. In general, the passive loss rules prohibit taxpayers from offsetting passive activity losses against active or portfolio income. However, Congress did provide a limited exemption which permits the deduction of certain rental real estate losses.

The Passive Loss Rule

IRC Sec. 469(c)(1) describes "passive activities" as trade or business activities in which the taxpayer does not "materially participate." Passive activities also include the taxpayer's rental activities. In general, losses from such activities can be offset only against income generated by passive activities. The effect of this restriction, typically, is to defer the deduction of such losses until future tax years when the passive activity either begins generating income, instead of losses, or until the taxpayer disposes of the passive activity investment.

Since premature disposition of an interest in a passive activity frequently is not economically feasible, taxpayers often seek to accelerate the deduction of their passive activity losses by investing in "passive income generators." As this label implies, passive income generators are passive activities that generate income, rather than losses. Income from these passive income generators then can be offset by the taxpayer's passive losses.

The Rental Real Estate Exception

Although passive losses generally cannot be deducted from a taxpayer's active or portfolio income, an important exception exists. IRC Sec. 469(i) permits the deduction of up to $25,000 of rental real estate losses, despite the fact that such losses are, by definition, passive losses. To qualify for this rental real estate exemption, the taxpayer must "actively participate" in the real estate venture. This active participation requirement limits the use of this exemption to those taxpayers, other than limited partners, who own at least a 10% percent interest in the rental real estate activity and who participate in the management of the rental property. This exemption is phased out as the taxpayer's adjusted gross income increases from $100,000 to $150,000.

As a result of these rules, taxpayers seeking to deduct passive activity losses either can invest in passive income generators or can attempt to qualify their passive activity under the rental real estate exemption. In a 1993 Tax Court decision, Cox v. Commissioner [TC Memo 1993- 326, 66 TCM 192 (1993)], the taxpayer achieved partial success in structuring his use of real property, which he owned with his wife, in a manner that could serve both purposes.

The Cox Strategy

The taxpayer and his wife purchased an office building as tenants by the entireties. Mr. Cox's law practice, a sole proprietorship, was located in this building. In 1987, Mr. Cox paid $18,000 rent to himself and his wife. On their joint return, Mr. Cox reported the entire $18,000 of rental payments as an expense on his Schedule C, and Mr. and Mrs. Cox reported the receipt of $18,000 of rental income and the payment of mortgage interest on their Schedule E. This strategy, if successful, would benefit the Coxes in three ways: 1) the additional rental income reported would be passive income against which previously nondeductible passive losses may be offset, 2) the rental expense deduction reported on Mr. Cox's Schedule C would reduce their adjusted gross income and make the rental real estate exemption more available, and 3) the rental expense deduction also would reduce Mr. Cox's net earnings from self-employment and consequently, his self-employment tax liability.

The Commissioner's Position. Upon examination, the commissioner disallowed the entire $18,000 of rental expense reported on Schedule C and deleted the corresponding rental income reported on Schedule E. By making payments to themselves, the commissioner reasoned, the Coxes were reallocating income improperly on their tax return in an attempt to convert ordinary income into passive income. If successful, the Coxes would be able to offset the newly created passive income with their passive losses that otherwise would not be deductible in the current taxable year.

The Taxpayer's Position. At trial, the Coxes relied heavily upon the fact that the rental property was owned by the taxpayers as tenants by the entireties, a special form of joint ownership between spouses. Treating this tenancy by the entireties as a separate legal entity, the Coxes argued that their method of reporting the rental transaction was not merely an attempt to reallocate income. Instead, the transaction was reported in a manner reflecting the true nature of the taxpayers' rights in the rental property.

The Tax Court's Analysis. With respect to the propriety of deducting the rental expense on Mr. Cox's Schedule C, the Tax Court noted that IRC Sec. 162(a)(3) permits the deduction of "rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity." The commissioner argued that, since Mr. Cox has an equity interest in the rental property, he is not entitled to deduct the $18,000 rental payment made by his sole proprietorship. Thus, the entire analysis hinged upon the nature of Mr. Cox's interest in the property.

Since the rental property was located in Missouri, the court referred to Missouri law for a determination of property rights. After a cursory review of the leading Missouri cases on tenancies by the entireties, the Tax Court made two key observations. First, each spouse is entitled to the use and enjoyment of the entire property held as tenants by the entireties. On the other hand, a spouse cannot unilaterally divest the other spouse of his or her interest in the property. Finally, the Tax Court considered a case, Rezabek v. Rezabek, where these principles were applied to rental property owned by tenants by the entireties.

In Rezabek, the Missouri Court of Appeals required the wife to account to her husband for the income received on the rental property. The accounting was ordered because the husband and wife each were entitled to one-half of the proceeds. Using the same rationale, the Tax Court ruled that Mr. Cox's equity interest did not include Mrs. Cox's interest in the property.

Dismissing the contention that the taxpayers' decision to file jointly had any bearing on the issue, the Tax Court found fault with the approaches used by both the taxpayers and the IRS. Since Mrs. Cox was entitled to one-half of the rental proceeds paid by the sole proprietorship to the Coxes, the Tax Court held that her $9,000 share of the rents was properly reported as rental income on Schedule E and as rental expense on Mr. Cox's Schedule C. However, due to the fact that Mr. Cox did possess an equity interest in one-half of the rental property leased by his sole proprietorship, the other half of the $18,000 rental payment was neither deductible by Mr. Cox's business nor reportable as rental income on the Cox's Schedule E.

Effect of the "Cox Strategy" on the Self-Employment Tax

Since the Cox case emphasized the effects of the passive loss rule, it is tempting to assume that the "Cox strategy" is only useful to sole proprietors with unused passive loss carryovers. This, however, is not the case. The strategy serves to reduce self-employment tax liability, as well.

The self-employment tax is a two-part tax imposed by IRC Sec. 1401 on a taxpayer's self-employment income. The Medicare portion of the tax is 2.9% of the taxpayer's "net earnings from self-employment." The Social Security portion is taxed at the higher rate of 12.4%, but this rate is applied only to the first $62,700 (in 1996) of self-employment income. "Net earnings from self-employment" is generally defined as the net income from the operations of a trade or business, reduced by one-half of the self-employment tax.

Since the Cox strategy generates a rental expense deduction for the sole proprietorship, the taxpayer's "net earnings from self-employment" are reduced. This, in turn, leads to a reduction in the self-employment tax liability for the self-employed spouse. To demonstrate the effect of the Cox strategy on the passive loss rule and the self-employment tax from the perspectives of the commissioner, the taxpayers, and the Tax Court, consider the following hypothetical example.

Example (see sidebar). Assume that Mr. Cox's net income from his law practice, without considering the rental payment for the use of his office, is $100,000 in 1996. As in the original case, assume that Mr. Cox paid $18,000 for rent of the office building owned by the Coxes as tenants by the entireties. Finally, assume that the Coxes have $15,000 of unused passive loss carryovers.

The use of the Cox strategy yields a total tax savings of $2,733 [$28.473-$25.740] as compared with the tax
liability that would be imposed if
the taxpayer had not rented from
his spouse.

Implications for Taxpayers
in Other States

As previously described, the Tax Court relied upon state law to determine the nature of Mr. Cox's equity interest in the rental real estate. After determining that Missouri's tenancy by entirety law entitled both the husband and the wife to one-half interests in the property, the Tax Court noted that this conclusion was consistent with prior Tax Court decisions concerning the treatment of income arising from tenancy by the entirety. Specifically, the court referred to tenancies by the entirety created in Delaware [Parsons v. Commissioner, 43 T.C. 378 (1964)], Maryland [Saulsbury v. Commissioner, 27 B.T.A. 744 (1933)], Michigan [Green v. Commissioner, 7 T.C. 142 (1946)], New York [Colabella v. Commissioner, TC Memo 1958-136 (1958)], and Oregon [Sandberg v. Commissioner, 8 T.C. 423 (1947)].

Thus, taxpayers in these states should be able to employ the "Cox strategy" successfully. Before attempting this strategy in other states, taxpayers must consult state law to ascertain whether the tenancy by entirety form of ownership is recognized and, if so, whether tenancy by entirety gives each spouse the right to a one-half interest in the property.

Every Bit Counts

In many states, the Cox strategy can be used by married taxpayers engaged in a trade or business as sole proprietors to improve their ability to deduct passive losses. Even if the sole proprietor does not have any passive loss problems, this strategy is worthy of investigation since it also can reduce the married taxpayer's self-employment tax liability. *

Kent N. Schneider, JD, CPA, is a professor of accountancy at East Tennessee State University.



Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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