IRS provides path for physicians to take advantage of their rental property losses
A recent IRS ruling issued in the form of a Technical Advice Memorandum (TAM)* ruled in favor of a physician’s tax treatment of his medical practice and ownership interest in an outpatient surgery center as separate activities under passive activity loss (PAL) rules. The ruling was based on several factors, including the lack of any direct relationship between the physician’s practice and his lack of control over the outpatient surgery center. The advantage to the physician is that now the outpatient surgery center is considered passive income, which can offset against rental property losses that would have otherwise been suspended and carried forward to future tax years.
Under the PAL rules of Code Section 469, losses of passive activities may only be used to offset passive activity income. Passive activity describes any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate. A taxpayer may “group together” the activities arising from the various trade, businesses, or rental activities as a single entity if the activities are deemed an
appropriate “economic unit” for measuring gain or loss for PAL purposes.
In certain cases, the IRS has the authority to regroup a taxpayer’s activities especially if the principal purpose of the grouping is to circumvent the PAL rules. These rules suspend otherwise deductible losses until passive activity is generated.
In the case at the center of the TAM ruling, the taxpayer was a physician who was an employee and percentage shareholder of two medical practices (both S corporations). Along with many other physicians, he also held a small ownership interest in a limited liability company that owned a percentage of an outpatient surgery center. The physician viewed this LLC as an alternative surgery location for his patients, and the investment had no impact on the income generated from either medical practice.
On the filing of their joint personal income tax returns, the physician and his wife treated the LLC “passive activity” as separate from the activity of the medical practices. The IRS, however, wanted to re-group the activities into one single economic unit, given that they all fell within the medical industry.
Ultimately, since the ownership interests and exercise of control over the medical practices differed from those of the outpatient surgery center, the taxpayer’s reported position of separate activities was upheld. As a result, he was able to utilize losses generated by a passive rental activity to offset the passive income generated by his investment in the outpatient surgery center. Had it not been for the passive income generated, the rental activity losses would have been suspended and carried over to another tax year.
Transactions subject to the PAL rules require careful consideration, but as this case demonstrates, can be incorporated into an effective part of an overall tax strategy.
*A technical advice memorandum (TAM) is a written interpretation of tax law as it relates to a specific problem presented by a specific taxpayer.
Deborah A. Nappi is senior manager of healthcare at Sax LLP.