Schedule E Losses on a Farm-Related Self-Rental, How to not have them classified as PALs?

[artyler1]

A Husband & Wife (H&W) own land, on which they operate a farm.  The farm has been incorporated as a 2-person LLC.  The H&W incurred personal debt to start the business, i.e., to construct the necessary agricultural buildings, purchase farm equipment, etc. 

At the suggestion of their attorney, a Deed of Lease was executed between the H&W and the LLC, under which the LLC pays rent for use of the land, “together with all improvements thereon”.  The H&W offset this income with their Interest Expense, RE Taxes, Depreciation, etc.  There’s taxable income until the Depreciation Expense, at which point there are sizable losses. 

Question:  What is the proper way to report this?  Because I MUST be doing something wrong, or missing something!  

I thought when this was reported on the Sch E, because it was a Self-Rental, and because it was part of a Trade or Business Activity, and because the H&W operate this farm themselves, any losses from the Sch E Rental would be claimable and would be netted against the flow-through Income from the LLC, for net taxable income to the taxpayers (approx. $108,000 total net), and all would be right with the world.

Instead, the system is trying to classify all the Sch E losses as PALs and disallow them, and tax all the income from the LLC, and all is NOT right with the world. 

Absent the Lease Agreement, all that Income and Expense would have stayed in the LLC and flowed through to the T/P’s F1040, and there’d be no question of Passive anything.

The only reason ANY of this started in the first place is because all the Mortgage Loans are being reported under the T/P’s SS# and there was question/concern raised about the LLC claiming a deduction for Mortgage Interest reported under the T/P’s Tax ID# on the LLC’s F1065, and from that, grew this situation. 

The agricultural buildings and equipment are being reported as part of the rental solely because they secure the loans, and it seemed logical to keep the loans and their collateral together. 

If the agricultural buildings and equipment are reported as assets of the LLC instead of the rental, the Depreciation Expense leaves the Sch E, and with it, the losses, and the problem.

Thoughts? (and if I've missed/forgotten something basic and you're about to tell me I'm an idiot, please be gentle  😕  lol)  And sorry it's so long, I blame COVID-19!

[BobKamman]

I figured out towards the end that they elected to be taxed as a partnership.  You start out with, "The farm has been incorporated as a 2-person LLC," which is something like saying the baby was baptized into the Jewish faith.  And you have already filed the Form 1065?  As I have pointed out elsewhere, this is the kind of stuff that hits the fan when you believe that LLC's are the solution to every problem.  Did they ask you before they set this up?  If not, suggest they go back to the lawyer for written advice on tax questions.  

IRS would do you a favor with an audit characterizing much of these as sham transactions. 

[Terry53029]

You say the partnership (1065) owns nothing, so the partnership will only put rent on the 1065, and any other income/expense of the partnership

The H/W will put rental income on schedule E.

My thoughts are, if this is their first year,is to be taxed as a Qualified Joint Venture not a partnership

How to Make the Election to be Treated as a Qualified Joint Venture

Spouses make the election on a jointly filed Form 1040 or 1040-SR by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse’s respective interest in the joint venture, and each spouse filing with the Form 1040 or 1040-SR a separate Schedule C (Form 1040 or 1040-SR), Profit or Loss From Business (Sole Proprietorship) or Schedule F (Form 1040 or 1040-SR), Profit of Loss From Farming and, if otherwise required, a separate Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax. For example, to make the election for 2019, jointly file your 2019 Form 1040 or 1040-SR, with the required schedules. The partnership terminates at the end of the taxable year immediately preceding the year the election takes effect. For information on how to report the business for the taxable year before the election is made, see Publication 541 on Partnerships and terminations.

[TaxGuyBill]

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@artyler1 wrote:

because it was a Self-Rental

Instead, the system is trying to classify all the Sch E losses as PALs and disallow them, and tax all the income from the LLC, and all is NOT right with the world. 

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Aren't losses from a Self-Rental (and also for rental of land) automatically passive?  Only gains are non-passive?

So that would mean the losses an only offset passive income (or up to $25,000 if income is under $150,000), right?

[sjrcpa]

You can't do that if it's an LLC (excepting perhaps in a community property state)

[sjrcpa]

You are correct.

[Terry53029]

I was thinking community property state, as I am in Wisconsin. Should have said that, sorry 🙂

[The_AntiTax_Man]

Did the attorney have a debt-over-basis issue? 

The LLC paid no rent to the taxpayer?

Farm has direct nexus between 1065 LLC and 1040. 

You could report on Sch F.

Or 2 Sch F's, his and hers.

[artyler1]

@Terry53029 and @TaxGuyBill,   

Thank you, I appreciate you reaching out on this.

And, I apologize for the confusion I created with my summary, I should have just said this:

H/W own the land, and they incurred approx. $1.5 million of personal debt to construct Turkey Houses & purchase necessary Turkey House Equipment.  Upon completion, a thriving Turkey farming business was started (which was being reported on dual Schs F on t/p’s F1040).  By Year 3 or 4, t/p’s Attorney said go LLC Partnership, and they did (2018 was mostly Sch F and little bit LLC, and no discussion of Sch E).  So, for 2019, what’s being rented to the LLC by the T/Ps are the Turkey Houses and Equipment necessary for them to operate and generate income, and the land on which they sit.  And the T/Ps are the 2 sole S/Hs, and the sole owner/operator/workers of the business, the LLC, and, in my mind, I thought this qualified as one of the exceptions to the PAL rules, but I couldn’t find anything about it in the IRS guidance, so I reached out here.  Now, it seems pretty clear, I was just wrong!!  lol  

However, seeing as I was so wrong about that, mind if I impose on you for one more small question?  I was the one that expressed concern over the LLC taking a deduction for mortgage interest that was being reported to the IRS under the t/p’s SS#, and out of that grew this Sch E situation, since the t/p & s/p were no longer going to have the Schs F. 

So, Was I wrong here too?  Would it have been acceptable to report it on the LLC’s t/r?  I reached out to a friend who’s an attorney, and he agreed with me, so I never consulted this board.  H&W are jointly liable for all the debt, and they’re 50-50 partners in the LLC Partnership.

Thanks in advance for your time and consideration.  I hope I haven't created any further confusion.

[artyler1]

Sorry @The_AntiTax_Man , I didn't see your reply before I posted my last message a moment ago, or I would've tagged you in it.

So you're saying the 2 dual Schs F, on which were previously reported the results of operations of the Turkey Farm, prior to the creation of the LLC, could be left open and now used to report the rent income, and the mortgage interest expense, depreciation expense, RE Taxes, etc.?

[The_AntiTax_Man · Accepted solution]

Yes, it sounds like there is a direct nexus between the 1065 and the 1040.  You will have to determine if there is.  

So, if the 1065 is paying rent to the 1040 [and LLC issued a 1099 to the 1040] report the rent income on 1040, Sch E, line 3 and the same amount as expense on line 19 labeled "To Sch F, line 7".  The Sch E will net to zero.  Report the rent on Sch F, line 7 and all other expenses on Sch F.