Classifying and reporting income and losses related to a land rent, such as a flat-surface parking lot, can be more difficult than you might think. Many complexities of the tax law come into play and will depend on your specific situation, namely on if you operate the parking lot as a business or if you lease the land to an operator. Both have different considerations and taxable outcomes that are important to record appropriately on your federal tax returns.
Operating the Parking Lot as a Business
If you are in the business of operating a parking lot, the first question to answer is "should income be reported as ordinary income or rental income?" A supplemental question to help answer that is, "Is this income subject to self-employment tax?"
The tax code excludes “rentals from real estate” from self-employment income; however, the IRS does not consider business activity from a parking lot as a rental from real estate situation. The income is treated as ordinary, so it is in fact subject to self-employment tax and must be reported as such.
Leasing the Land to an Operator
On the other hand, if you lease the land to an outside party, who then operates the business of a parking lot, the classification of income becomes much more difficult to determine.
In this scenario, the operating company is paying you, the lessor, for the right to run their business on this property. First question: ‘Should this be reported as self-employment income as in the scenario above?’ The answer is no, as you are not rendering services to your occupants, like an operator. You are simply leasing the land to a tenant, who then is using that land to operate their business.
The next logical question to ask is: ‘Is this passive income?’, since all you are doing is leasing land to a tenant for them to operate their business. At first glance the tax code, specifically Section 469(c)(2), agrees, stating that "the term 'passive activity' includes any rental activity." Accordingly, rental activities are passive and should be reported on the Form 8825 Rental Real Estate Income and Expenses along with other rental real estate activities, i.e. rental of a parking lot, right?
Not necessarily. While net losses from land rents are reported as passive, it’s a little more complicated in years with net taxable income. Regulation 1.469-2T(f)(1) creates rules regarding the recharacterization of passive income from "certain passive activities to be treated as income that is not from a passive activity." Section (f)(3) of that regulation applies to a taxpayer leasing land to an operator:
"If less than 30 percent of the unadjusted basis of the property … in a rental activity is subject to the allowance for depreciation … the taxpayer's net passive income from the activity shall be treated as not from a passive activity."
For a land lease, where the only asset (or majority of the property) is the land, the taxpayer obviously does not have depreciable assets that make up more than 30% of the unadjusted basis of the property. So, the income from a passive activity is going to be recharacterized as non-passive income.
No longer thought of as passive, should the income be reported as portfolio income? Not according to Regulation 1.469-2T(c)(3), which defines portfolio income as income attributable to items such as interest, annuities, royalties, dividends on C Corporation and S Corporation stock, income from real estate investment trust, disposition of property held for investment, among others. A land lease does not fit into any of these categories either.
Ultimately, net income from a land lease does not have a classification into which income fits nicely. While the IRS has issued plenty of guidance on what this income is not, there is little support on what it is and how it should be reported.
Without a definitive line or form specifically for this sort of income, reporting it as "Other Income" on Schedule K, with a footnote that this income is from a land lease, may be the best option currently available. While this seems like a catch-all spot to record this income, the main objective is to not characterize this as passive income, which can be offset with passive losses, or self-employment income, which will subject you to additional taxation.
Please contact a member of your service team, or contact David Charles at firstname.lastname@example.org or Kim Palmer at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.