4) Last year, Juan, a real estate developer, purchased 25 acres offarmland on th

Question

4)

Last year, Juan, a real estate developer, purchased 25 acres offarmland on the outskirts of town for $100,000. He expects that theland’s value will appreciate rapidly as the town expands inthat direction. Since the property was recently reappraised at$115,000, some of the appreciation has already taken place. Toenhance his return from the investment, Juan decides he will beginrenting the land to a local farmer. He has determined that a fairrent would be at least $1,500 but no more than $3,500 per year.Juan also has an interest in a passive activity that generates a$2,800 loss annually. How do the passive loss rules affectJuan’s decision on how much rent to charge for thefarmland?

Explanation / Answer

Juan owns a passive activity that currently produces an annual $2,800 loss that is not deductible because of the absence of passive income.  By deciding to rent the land, Juan hopes to have the rent income classified as passive income.  As a result, the $2,800 loss can be deducted up to the amount of the rent income.  Therefore, a key consideration is setting the rent at a level so as to insure that it will be treated as passive income.  For the rent income to be treated as income from a passive activity, the rent charge must be at least 2% of the property’s unadjusted basis.  Therefore, the rent income should be at least $2,000 ($100,000 X 2%).  If Juan sets the rent at any amount less than $2,000, the entire receipt will be treated as income that is not from a passive activity.  In such a case, the $2,800 passive loss could not be deducted and would be suspended.

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