My last column focused on the tax treatment of payments for sequestering carbon. The discussion assumed that payments constituted rent because the landowner had not disposed of either the land or the timber. In my next column I'll discuss carbon sequestration contracts that may constitute a disposal and therefore require capital gains treatment of some portion of the payments received. In this column I look more closely at the treatment of rental activities.
This discussion is relevant to Tree Farmers receiving rental payments for carbon sequestration, hunting rights, recreational use, or other activities carried out by parties other than the landowners. After introducing the treatment of rental activities generally, I'll unfortunately have to discuss the implications of the passive loss rules. The major issue is the circumstances under which receipt of rental income makes it necessary to report this activity separately from your other activities, such as timber production.
Rental Activities
Rent is payment received for use of your property by another party. Payments constitute rent when a land-lord-tenant relationship exists either explicitly under the terms of a lease contract or implicitly based on the relationship between the landowner and the party using the land. The agreement may be for a specified time period or on a year-to-year basis. The landlord makes the land available to the tenant and doesn't interfere with his "quiet enjoyment" of it. The tenant's use is limited to that allowed under the agreement. The landowner usually has expenses directly related to the production of income in the form of rent.
Tax laws make a clear distinction between investment, business, and rental activities. The term "investment" is used here in the income tax context, i.e., a for-profit activity that doesn't rise to the level of a business. The owner of a business is directly and personally involved in its conduct wit the goal of realizing a profit. A rental activity is inherently passive for purposes of this discussion since is doesn't include real estate professionals with extensive holdings or rental property. If the activity generating the rent constitutes a separate activity for tax purposes, rental income and expenses are reported on Form 1040, Schedule E, Part I: Income or Loss From Rental Real Estate and Royalties. Expenses reported on Schedule E are not subject to the two-percent of adjusted gross income hurdle required for miscellaneous deductions to result in a deduction. This limit applies to investment expenses other than property tax. Thus, rental expenses are, in effect, and adjustment to gross income or, as the tax professionals say, "an above the line deduction." If the rent received in a year exceeds the expenses associated with the rental activity, the result is passive income that can offset passive losses from other activities. If the rental activity results in a loss, however, its deductibility may be restricted by the passive loss rules.
Passive Loss Rules
Passive activities are businesses in which the owner does not "materially participate" in the conduct of the business and all rental activities. Many Tree Farmers are considered to be materially participating in their Tree Farm business based on the undefined "facts and circumstances" test, but this is an issue that's on the agendas of Washington D.C. representatives of forest landowner organizations. Investment activities are not subject to the passive loss restrictions. A rental activity is passive even if the owner would otherwise be considered to be materially participating. However, under limited circumstances the rental activity may be classified as incidental to other activities associated with a Tree Farm. The receipt of rent doesn't constitute a separate rental activity if it is incidental to a non-rental investment or business activity. For investment activities rental is incidental only if the property is held primarily to realize a gain from appreciation in the value of the property and gross rental incomes is less than two percent of the lesser of the Tree Farm's unadjusted basis or its fair market value.
If a Tree Farm is part of a business, rental income is incidental if it meets the two-percent test and the property was used predominantly in the trade or business activity during the tax year or in two of the immediately preceding five years. Meeting the two-percent test may be a challenge for many Tree Farmers because of their small basis. Recall that the basis is the "book value" of the land and the timber for tax purposes based on the purchase price, date of death fair market value in the case of inherited assets, and the adjusted basis of the giver in the case of gifts. If this test is met then the rental activity can be treated as part of the other investment or business activities and material participation determined if it's a business by including the hours worked in all the activities. If the basis is too low to meet this two-percent test, there's also a limited exception to the passive loss restrictions for relatively small losses from rental activities.
Up to $25,000 of passive losses and the deduction equivalent of tax credits attributable to rental real estate may be used to offset income from other non-passive sources, such as salary, wages, dividends and interest. A Tree Farmer must have "actively participated" in the activity, a lesser standard than "materially participate" to qualify for this exception. The active participation standard is met if you or your spouse make the major management decisions, such as approving the party renting the land, the rental rate, and contracting with vendors such as consulting foresters or wildlife scientists to provide needed services. You must have at least 10-percent ownership interest in the land rented. The ownership interest of your spouse can be included in determining this pecentage. The exception only applies to individual taxpayers and some estates. There is also a phase-out based on adjusted gross income (AGI) of the spouses. The $25,000 maximum amount is reduced by 50 percent of the amount by which AGI exceeds $100,000 for married filing jointly, and $50,000 for single or married filing separately.
Implications
There may be circumstance under which it is to a Tree Farmer's advantage to file as a rental activity. This may be the case if rent is the major source of income, there are not other significant activities taking place, and the activity would otherwise need to be reported as investment activity. If losses are frequently generated, ideally there's active participation and the $25,000 exception can be used to avoid dealing with the passive loss restrictions. If there's no advantage to filing as a rental activity, the two-percent rule for combining the rental activity with other investment or business activities for which the Tree Farm is used would allow the hours worked in all the activities to be combined, and avoid the passive loss restrictions by qualifying as materially participating in the combined activities. even when all activities take place on the same land there may be cases where it's advisable to file both Schedule E for the rental activity and the appropriate tax form for the business activity. This would require allocating joint expenses between the two activities based on the primary purpose for each and the proportion of revenue generated by the rental and business activities.
Given all the factors to be considered it's obvious that any change in how your currently filing needs to be discussed with your tax advisor.