Amendments to Passive Activity Regs Clarify Developer Rule -- Temporary and Proposed Regulations Under Section 469

 [4830-01]

 ACTION: Amendments of temporary regulations.

 SUMMARY: This document amends the temporary regulations relating to the limitations on passive activity losses and passive activity credits. The amendments clarify the treatment of lease-up services under the net income recharacterization rule for certain property the rental of which is incidental to development activity. The text of the temporary regulations also serves as the text of the proposed regulations for the notice of proposed rulemaking on this subject. The notice of proposed rulemaking appears in the Proposed Rules section of this issue of the Federal Register.

 EFFECTIVE DATE: These amendments of the regulations are effective for taxable years beginning after December 31, 1987.

 FOR FURTHER INFORMATION CONTACT: Dexter A. Johnson at 202-566-4751 (not a toll-free number), or at Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Room 4429, Washington, D.C. 20044 (Attn: CC:CORP:T:R (PS-071-89)).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Section 1.469-2T(f)(5) reduces a taxpayer's passive activity gross income by the net income and gain from certain rental property. This rule applies to certain property that is not used in an activity involving the rental of the property for a period of at least 12 months between its development and its disposition. A taxpayer is subject to the rule if the taxpayer materially or significantly participated for any taxable year in an activity that involved for that year the performance of services for the purpose of enhancing the property's value.

 Section 1.469-2T(f)(5)(ii) provides that the use of property in an activity involving its rental begins when the performance of value-enhancing services is complete and substantially all of the property is first held out for rent and is in a state of readiness for rental. Under section 1.469-2T(f)(5)(iii)(C), services performed for the purpose of enhancing the value of property include "lease-up" (e.g., the solicitation of tenants) if, as of the time the taxpayer acquires an interest in the property, a substantial portion of the property is not leased. Numerous commentators have asked when lease- up is complete for purposes of commencing the 12-month rental period preceding a disposition of property. Commentators have also asked for guidance on when a substantial portion of property is not leased.

TREATMENT OF LEASE-UP CLARIFIED

 These amendments of the regulations clarify that lease-up is treated as a value-enhancing service under section 1.469-2T(f)(5) unless more than 50 percent of the property is leased when the taxpayer acquires an interest in the property. The Internal Revenue Service has determined that this objective test will help taxpayers determine whether lease-up is a value-enhancing service in any given case.

 Although lease-up may be treated as a value-enhancing service under the net income recharacterization rule in section 1.469-2T(f)(5), the Service believes that the commencement of the 12-month rental period should not be delayed until lease-up has been completed. Accordingly, these amendments of the regulations clarify that property is used in an activity involving its rental beginning on the first date on which (1) the taxpayer owns an interest in the item of property, (2) substantially all of the property is rented (or is held out for rent and is in a state of readiness for rental), and (3) no significant value-enhancing services (within the meaning of section 1.469-2T(f)(5)(ii)(B)) remain to be performed. Under section 1.469-2T(f)(5)(ii)(B), significant value-enhancing services excludes lease-up.

 These amendments of the regulations apply as if they had been included in section 1.469-2T(f)(5) as promulgated in Treasury Decision 8175, 53 FR 5686, February 25, 1988, and as amended by Treasury Decision 8253, 54 FR 20527, May 12, 1989. Under section 1.469-11T(a)(2), section 1.469-2T(f)(5) applies for taxable years beginning after December 31, 1987.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553 (b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

DRAFTING INFORMATION

 The principal author of these regulations is Dexter A. Johnson, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations on matters of both substance and style.

LIST OF SUBJECTS IN 26 CFR 1.441-2 THROUGH 1.483-2

 Accounting, Deferred compensation plans, Income taxes.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, Title 26, Chapter 1, Part 1 of the Code of Federal Regulations is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953.

Paragraph 1. The authority for Part 1 continues to read in part:

Authority: 26 U.S.C. 7805. * * * Sections 1.469-1T, 1.469-2T, 1.469-3T, 1.469-5T, and 1.469-11T. also issued under 26 U.S.C. 469(l).

Par. 2. Section 1.469-2T is amended as follows: Paragraph (f)(5)(i)(B), (ii), (iii)(C), and (iv) is revised to read as set forth below.

SECTION 1.469-2T PASSIVE ACTIVITY LOSS (TEMPORARY).

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(f) RECHARACTERIZATION OF PASSIVE INCOME IN CERTAIN SITUATIONS. * * *

(5) NET INCOME FROM CERTAIN PROPERTY RENTED INCIDENTAL TO DEVELOPMENT ACTIVITY -- (i) * * *

(B) The taxpayer's use of the item of property in an activity involving the rental of the property commenced less than 12 months before the date of the disposition (within the meaning of paragraph (c)(2)(iii)(B) of this section) of such property; and

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(ii) COMMENCEMENT OF USE -- (A) IN GENERAL. For purposes of paragraph (f)(5)(i)(B) of this section, a taxpayer's use of an item of property in an activity involving the rental of the property commences on the first date on rental of the property commences on the first date on which --

(1) The taxpayer owns an interest in the item of property;

(2) Substantially all of the property is rented (or is held out for rent and is in a state of readiness for rental); and

(3) No significant value-enhancing services (within the meaning of paragraph (f)(5)(ii)(B) of this section) remain to be performed.

(B) VALUE-ENHANCING SERVICES. For purposes of this paragraph (f)(5)(ii), the term "value-enhancing services" means the services described in paragraphs (f)(5)(i)(C) and (iii) of this section, except that the term does not include lease-up. Thus, in cases in which this paragraph (f)(5) applies solely because substantial lease- up remains to be performed (see paragraph (f)(5)(iii)(C) of this section), the twelve month period described in paragraph (f)(5)(i)(B) of this section will begin when the taxpayer acquires an interest in the property if substantially all of the property is held out for rent and is in a state of readiness for rental on that date.

(iii) * * *

(C) Lease-up (unless more than 50 percent of the property is leased on the date that the taxpayer acquires an interest in the property).

(iv) EXAMPLES. The following examples illustrate the application of this paragraph (f)(5):

EXAMPLE (1). (i) A, a calendar year individual, is a partner in calendar year partnership P, which develops real estate. In 1988, P acquires an interest in undeveloped land and arranges for the financing and construction of an office building on the land. Construction is completed in February 1990, and substantially all of the building is either rented or held out for rent and in a state of readiness for rental beginning on March 1, 1990. Twenty percent of the building is leased as of March 1, 1990.

(ii) P rents the building (or holds it out for rent) for the remainder of 1990 and all of 1991, and sells the building on February 1, 1992, pursuant to a contract entered into on January 15, 1991. P did not hold the building (or any other buildings) for sale to customers in the ordinary course of P's trade or business (see paragraph (c)(2)(v) of this section). A's distributive share of P's taxable losses from the rental of the building is $50,000 for 1990 and $30,000 for 1991. All of A's losses from the rental of the building are disallowed under section 1.469-1T(a)(1)(i) (relating to the disallowance of the passive activity loss for the taxable year). A's distributive share of P's gain from the sale of the building is $150,000. A has no other gross income or deductions from the activity of renting the building.

(iii) The real estate development activity that A holds through P involves in 1988, 1989, and 1990 the performance of services (e.g., construction) for the purpose of enhancing the value of the building. Accordingly, an amount equal to A's net rental activity income from the building may be treated as gross income that is not from a passive activity if A's use of the building in an activity involving the rental of the building commenced less than 12 months before the date of the disposition of the building. In this case, the date of the disposition of the building is January 15, 1991, the date of the binding contract for its sale.

(iv) A taxpayer's use of an item of property in an activity involving the rental of the property commences on the first date on which (A) the taxpayer owns an interest in the item of property, (B) substantially all of the property is rented (or is held out for rent and is in a state of readiness for rental), and (C) no significant value-enhancing services (within the meaning of paragraph (f)(5)(ii)(B) of this section) remain to be performed. In this case, A's use of the building in an activity involving the rental of the building commenced on March 1, 1990, less than 12 months before January 15, 1991, the date of disposition. Accordingly, if A materially (or significantly) participated in the real estate development activity in 1988, 1989, or 1990 (without regard to whether A materially participated in the activity in more than one of those years), an amount of A's gross rental activity income from the building for 1992 equal to A's net rental activity income from the building for 1992 is treated under this paragraph (f)(5) as gross income that is not from a passive activity. Under paragraph (f)(9)(iv) of this section, A's net rental activity income from the building for 1992 is $70,000 ($150,000 distributive share of gain from the disposition of the building minus $80,000 of reasonably allocable passive activity deductions).

EXAMPLE 2. (i) X, a calendar-year taxpayer subject to section 469, acquires a building on February 1, 1992, when the building is 25 percent leased. During 1992, X rents the building (or holds it out for rent) and materially participates in an activity that involves the lease-up of the building. X's activities do not otherwise involve the performance of construction or other services for the purpose of enhancing the value of the building, and X does not hold the building (or any other building) for sale to customers in the ordinary course of X's trade or business. X sells the building on December 1, 1992.

(ii) Under paragraph (f)(5)(iii)(C) of this section, lease-up is considered a service performed for the purpose of enhancing the value of property unless more than 50 percent of the property is leased on the date the taxpayer acquires an interest in the property. Under paragraph (f)(5)(ii)(B) of this section, however, lease-up is not considered a value-enhancing service for purposes of determining when the taxpayer commences using an item of property in an activity involving the rental of the property. Accordingly, X's acquisition of the building constitutes a commencement of X's use of the building in a rental activity, because February 1, 1992 is the first date on which (A) the taxpayer owns an interest in the item of property, (B) substantially all of the property is held out for rent, and (C) no significant value-enhancing services (within the meaning of paragraph (f)(5)(ii)(B) of this section) remain to be performed. In this case, X disposes of the property within 12 months of the date X commenced using the building in a rental activity. Accordingly, an amount of X's gross rental activity income for 1992 equal to X's net rental activity income from the building for 1992 is treated under this paragraph (f)(5) as gain that is not from a passive activity.

EXAMPLE 3. The facts are the same as in example (2) except that at the time X acquires the building it is 60 percent leased. Under paragraph (f)(5)(iii)(C) of this section, lease-up is not considered a service performed for the purpose of enhancing the value of property if more than 50 percent of the property is leased on the date the taxpayer acquires an interest in the property. Therefore, additional lease-up performed by X is not taken into account under this paragraph (f)(5). Since X's activities do not otherwise involve the performance of services for the purpose of enhancing the value of the building, none of X's gross rental activity income from the building will be treated as income that is not from a passive activity under this paragraph (f)(5).

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There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason, it is impracticable to issue this Treasury decision with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section.