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January 11, 2018 - Haoshen Zhong

Active Rental Income Exception to Passive Income

Active rental income

This is a question we received through an email:

I own stock of a foreign real estate investment trust (REIT). It is a corporation under US tax law. It owns a hotel and rents rooms directly. It outsources the management of the hotel to an unrelated entity, but it has all the legal and contractual relationships with the guests.

In this post, I will discuss why this type of rental income is passive, which causes the REIT to be a passive foreign investment company (PFIC).

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either: * An income test: 75% or more of its gross income is passive income, or * An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income. A foreign corporation that satisfies either test is a PFIC.

Rent usually is passive

Passive income is income that would be foreign personal holding company income in the hands of a controlled foreign corporation. IRC §1297(b). Foreign personal holding company income includes dividends, interest, royalties, rent, annuities, gains from properties that produce the above income, gains from properties that do not produce income, commodities gains, foreign currency gains, and payment in lieu of these types of income. IRC §954(c). It covers income that we normally think of as passive investment income. Rent normally is passive income.

Exception for active rent

There is an exception when the rent is from an active business:

[Passive income] does not include rents and royalties which are derived in the active conduct of a trade or business and which are derived from a person other than a related person… IRC §954(c)(2)(A).

Here, the hotel rental is an active trade or business: It requires many people to manage the hotel. The hotel has to provide services to its guests. The hotel has to advertise itself. It takes a lot of time and resources to run the hotel. Certainly the hotel is an active business.

The REIT needs to be engaged in the business

The regulations narrow the active rent exception into 4 categories, each of which requires the foreign corporation claiming the exception to participate in an active trade or business. Reg. §1.954-2(c)(1). Let us go through each category and see why none applies.

REIT is not a construction company

Under the first exception, rent is nonpassive if it is from leasing:

Property that the lessor, through its own officers or staff of employees, has manufactured or produced […] but only if the lessor, through its officers or staff of employees, is regularly engaged in the manufacture or production of […] property of such kind. Reg. §1.954-2(c)(1)(i).

This is an exception for construction companies that also rent out what they build. It does not apply to a REIT that holds only 1 hotel. Also, it requires the company to construct the property through its own officers or staff of employees. The REIT in our scenario outsources all its activities to an unrelated third party.

REIT is not actively managing or operating the hotel

Under the second exception, rent is nonpassive if it is from leasing:

Real property with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased. Reg. §1.954-2(c)(1)(ii).

Here, the REIT outsources all management activities to an unrelated third party. It does little in managing the hotel business, either through its own officers or its own employees. The REIT’s rental income does not qualify for this exception.

Not temporary rental of business property

Under the third exception, rent is nonpassive if it is from leasing:

Property ordinarily used by the lessor in the active conduct of a trade or business, leased temporarily during a period when the property would, but for such leasing, be idle. Reg. §1.954-2(c)(1)(iii).

This exception exists for a business that wants to get some extra use out of business property that is idle temporarily. For example, a trucking business might rent one of its trucks to another business if its own business is slow, but it does not want to leave its trucks idle. Here, the REIT does not have a business other than the hotel business in which it uses the hotel. This exception does not apply to the hotel.

REIT does not perform marketing

Under the fourth exception, rent is nonpassive if it is from leasing:

Property that is leased as a result of the performance of marketing functions by such lessor through its own officers or staff of employees located in a foreign country or countries, if the lessor, through its officers or staff of employees, maintains and operates an organization either in such country or in such countries (collectively), as applicable, that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property. Reg. §1.954-2(c)(1)(iv).

A corporation can claim this exception if it outsources management of its properties to a third party, but it reserves for itself the marketing function for the property. Here, there is nothing that suggests the REIT is in the business of marketing its own property, so it cannot claim this exception. Because it meets none of the 4 categories described in the Regulations, the REIT’s rent does not qualify for the active rent exception to passive income. There is an active hotel business, but because the REIT does not participate in the business, it cannot use the active rent exception. The REIT is a PFIC.

PFIC and CFCs