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Sharma v. Commissioner (T.C. Memo. 2020-147)

On October 29, 2020, the Tax Court issued a Memorandum Opinion in the case of Sharma v. Commissioner (T.C. Memo. 2020-147). The primary issue before the court in Sharma was what portion of the petitioners’ loss deduction from rental real estate activities claimed on Schedule E (Supplemental Income and Loss), is disallowed under the IRC § 469(a) and (i) limitations on the deductibility of passive activity losses.

Background

In calculating their 2014 AGI, petitioners deducted a loss of $27,000 from rental real estate activities detailed on Schedule E of their 2014 Form 1040. Separate from their return, the petitioners also submitted to the IRS a Form 8582 (Passive Activity Loss Limitations), on which they reported that they were permitted to claim the full amount of their Schedule E loss for 2014.  The IRS filed a notice of deficiency, the petitioners filed a Tax Court petition for redetermination, and here we are.

Passive Activity Loss Deductions

Taxpayers may claim deductions for certain business and investment expenses. IRC § 162; IRC § 212. However, any deduction for a “passive activity loss” for a taxable year is disallowed, and the disallowed loss is carried forward to the next taxable year. See IRC §§ 469(a) and (b). A passive activity loss is the amount by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year. IRC § 469(d)(1). A “passive activity,” in turn, is any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate. See IRC § 469(c)(1).

Rental activities are generally treated as per se passive activities regardless of whether the taxpayer materially participates. See IRC §§ 469(c)(2), (4). There are, however, two significant exceptions to this general rule. First, it does not apply to rental activities of taxpayers engaged in certain real property trades or businesses.  IRC § 469(c)(7). Such activities are instead subject to the material participation requirements of IRC § 469(c)(1). Id. Second, IRC § 469(i) provides an exemption permitting individuals who actively participate in rental real estate activities to deduct up to $25,000 in annual losses from such rental activities. See IRC § 469(i)(1) and (2).

The $25,000 maximum exemption is subject to a phaseout that reduces the exemption by 50% of the amount by which a taxpayer’s “modified adjusted gross income” (MAGI) for the taxable year exceeds $100,000. See IRC §§ 469(i)(3)(A), (F). Consequently, if a taxpayer’s MAGI is $150,000 or more, the IRC § 469(i) exemption is fully phased out. Spouses who have filed a joint return are treated as a single taxpayer for purposes of the MAGI calculation, and both spouses’ income therefore must be taken into account in calculating their MAGI. Opperwall v. Commissioner, 105 F.3d 666, 666 (9th Cir. 1997); Treas. Reg. § 1.469-1T(j)(1).

Calculating MAGI

The IRS argues that IRC § 469(i)(3)(F) should control the calculation. IRC § 469(1)(3)(F) provides that for purposes of the IRC § 469(i) exemption, “adjusted gross income shall be determined without regard to” the following items: (1) the taxable portion of Social Security benefits that would be included in gross income under IRC § 86; (2) the exclusion from gross income of amounts received upon redeeming U.S. savings bonds in the circumstances described in IRC § 135; (3) the exclusion from gross income of adoption assistance payments in the circumstances described in IRC § 137; (4) the IRC § 199 deduction for income attributable to domestic production activities; (5) the IRC § 219 deduction for qualified contributions to a retirement plan; (6) the IRC § 221 deduction for education loan interest payments; (7) the IRC § 222 deduction for qualified tuition expenses; and (8) any passive activity loss (including any passive activity loss allowable under the IRC § 469(c)(7) exception for taxpayers engaged in a real estate trade or business).

The petitioners contend that the IRS’s calculation should be reduced by certain IRA distributions and distributions from pensions and annuities that the petitioners received for 2014. These additional adjustments would result in a lower MAGI, and the IRC § 469(i) phaseout would no longer apply. In support of their calculation petitioners cite the instructions for Form 8582.

The Court Weighs In

The instructions for Form 8582 address only situations in which a taxpayer has contributed to a retirement plan during the taxable year. The petitioners did not report on their return, and do not contend that they made, any payment to an IRA or other retirement plan in 2014. Instead, they reported that they received distributions from an IRA and other retirement plans during that year. The portion of the Form 8582 instructions on which petitioners rely does not in any way suggest that money received from a retirement plan during the taxable year should be subtracted when calculating MAGI.

The relevant portion of the form’s instructions corresponds to IRC § 469(i)(3)(F)(iii), which provides that a taxpayer’s MAGI is calculated without regard to the amount allowable as a deduction under IRC § 219. IRC § 219 allows taxpayers to deduct their qualified retirement contributions for a taxable year, including any amount paid in cash for the taxable year by or on behalf of an individual to an individual retirement plan for such individual’s benefit and any amount contributed on behalf of an individual to a plan described in IRC § 501(c)(18). See IRC §§ 219(a), (e). The amount allowable as a deduction under IRC § 219 is subtracted from gross income when calculating AGI. IRC § 62(a)(7).

Since IRC § 469(i)(3)(F)(iii) directs that MAGI for purposes of IRC § 469(i) must be calculated without regard to any otherwise allowable IRC § 219 deduction, the effect of that provision would be to increase, not decrease, the petitioners’ MAGI if they had made any retirement contributions for 2014. But here, as The Tax Court has noted, the petitioners did not contribute any money to a retirement plan for 2014, and IRC § 469(i)(3)(F)(iii), therefore, does not affect the calculation of their MAGI.

(T.C. Memo. 2020-147) Sharma v. Commissioner

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