Magazine article The CPA Journal

The Cox Strategy: How to Reduce Taxes by Renting from Your Spouse

Magazine article The CPA Journal

The Cox Strategy: How to Reduce Taxes by Renting from Your Spouse

Article excerpt

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 u Commissioner [TC Memo 1993326, 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 selfemployment and consequently, his selfemployment tax liability.

The Commissions 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. …

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