Problem
Eddie Sanchez, a California resident, is the founder of Sanchez Pharmaceuticals ("Sanchez Pharma"), a general partnership with two owners: Eddie with a 90% partnership interest and Bret, an unrelated senior researcher with a 10% partnership interest. Their efforts have resulted in making Sanchez Pharma a very profitable business. Eddie and Bret materially participate in Sanchez Pharmaceuticals.
Eddie also owns two rental properties. The first is a commercial building located in a small industrial park in Anaheim, California. Eddie rents the building to Sanchez Pharma. The rent is set to just cover the costs, so he breaks even on it for tax purposes.
The second rental property is a condo located on the west coast of Florida. Eddie rents the condo to tourists from the Midwest looking to spend a week on the Florida beaches. Unfortunately, a few years ago a new flashy condo development was constructed nearby. As a result, his rent revenue declined substantially resulting in a loss of about $20,000 each year for the last five years. Eddie has income well in excess of $500,000 each year and was unable to deduct any of these losses due to the passive loss rules. As you might imagine, this does not make him very happy. According to Eddie, it's bad enough to have a loss each year and even worse to not get a tax deduction for it!
This year Eddie has approached you with an idea. Now that his business is generating profits, he is going to raise the rent on the warehouse building and generate at least $20,000 of rental income each year. His perspective is that the income he generates from leasing the warehouse building to Sanchez Pharma will offset his losses from the Florida condo on his tax return. He expects his plan will result in an overall tax savings since the partnership income will be reduced due to the higher rent expense, and the additional rent income will be offset by the condo rental losses. Will Eddie the rental income on his warehouse allow him to deduct the rental losses on the condo?
Is the rental income from the commercial building considered passive income?