SHOPPING CENTER ASSOCIATION SAYS PASSIVE ACTIVITY RULES ARE TOO STRICT AND TILTED IN FAVOR OF 'MORE ESTABLISHED DEVELOPERS.'

The International Council of Shopping Centers (ICSC) respectfully submits the following comments on the temporary regulations issued on February 19, 1988 on Limitations On Passive Activity Losses And Credits.

ICSC is the trade association of the shopping center industry. Its members include developers, owners, lenders, retailers, and all others having a professional interest in the shopping center industry. ICSC has about 26,000 members worldwide. Its 23,000 members in the U.S. own and manage most of the 30,600 shopping centers in this country.

SUMMARY

The temporary regulations should be withdrawn and substantially modified for the following reasons:

o The objective of the regulations should be to create a workable framework to implement the passive loss limitation rules, not to provide a detailed series of individual rules attempting to characterize all losses as passive and all income as active or portfolio.

o They unfairly penalize smaller and start-up developers. Given the complexity of the rules and the many arbitrary ways the rules are implemented, it will be difficult or impossible for all but the wealthiest taxpayers to plan for them and to report income properly using them.

o They create an impossible administrative burden for taxpayers and the IRS alike.

o The entire approach taken in drafting the regulations is improper. Bright line rules should be established as safe harbors. They cannot be used effectively as principal rules themselves. The result of the approach taken is a patchwork of independent rules unlinked by any overall theory or rationale which will be impossible for practitioners to anticipate. For example, it does not make sense to characterize income on the sale of a building developed, rented and sold within two years as active income if the same scenario would result in passive income if the building were rented for two years and one day before the sale. A general rule and a "more than two years" safe harbor test would eliminate this type of arbitrary and rigid result.

o Although the regulations indicate that it is not necessary to maintain daily appointment books or diaries, the result of the use of an hours worked test for determining material participation, almost to the exclusion of all other factors, practically necessitates that daily logs be kept. This is an unfair burden and one which will be impossible to implement. Further, the emphasis on hours worked is a major deviation from the broad concepts outlined by the Senate Finance Committee Report for delineating material participation from participation which is not material. This deviation destroys what could have been a more reasonable and balanced approach had the Committee Reports been followed.

o The regulations deviate considerably from the concepts and theories contained in the Committee reports. This puts taxpayers who have planned transactions during the period from the enactment of the 1986 Act until the issuance of the proposed regulations in an unfair position of facing penalties for violating rules they could not possibly have anticipated.

o The rules are overly complex and unworkable. They unfairly infringe on regular business practices and will result in inadvertant non-compliance which could trigger unfair penalty and nondeductible interest charges even in the face of a good faith attempt to comply with the rules.

DEFINITION OF PASSIVE ACTIVITY

Code Section 469(c)(2) provides that the term passive activity includes any rental activity. Reg. Sec. 1.469-1T(e)(1)(ii). The temporary regulation define the term rental activity and provides certain exceptions to the definition of rental activity to exclude certain rental activities as contemplated by the Committee Reports. These exceptions are narrowly drafted so as to include all ownership of a broad range of rental activities.

This approach presents significant practical problems which cannot be fully appreciated until the regulation defining the scope of an activity are issued. The key point which the proposed regulations don't properly address is whether these rules should be applied to the person who is actively engaged in developing, leasing, renovating, managing, operating and buying shopping centers. It is highly questionable whether these rules can be applied in an administratively reasonable manner in these circumstances. For an active shopping center developer to have to segregate leasing, management, development and other activities which may be deemed to be "active" for Code Section 469 purposes, from rental operations (the ownership and rental of the shopping center) which, according to this section of the temporary regulations will always be "passive" for purposes of Code Section 469, will create an administrative nightmare, penalize smaller and start-up developers far more heavily than larger developers who have been in business for many years (for example see the discussion below concerning the sale of a shopping center within two years of development), and will result in considerable disputes and litigation between taxpayers and the Internal Revenue Service ("IRS").

More established developers can probably afford more sophisticated tax counsel to deal with the complexity of the regulations and thus are less likely to be penalized than newer developers. More established developers will also have more flexibility to plan for the passive loss limitations. For example, an established developer may be able to waive fees normally obtained during the development stage (which would be active income) and substitute a greater interest in partnership distributions (which would be passive income and would offset passive losses). Newer and smaller developers will not be able to afford to wait to obtain the larger distributions -- they will need funds during the development process to fund their activities.

DEFINITION OF RENTAL ACTIVITY

An activity is deemed to be a rental activity where tangible property held in connection with the activity is used by customers and the gross income attributable to the conduct of the activity during such taxable year represents amounts paid principally for the use of such tangible property. Reg. Sec. 1.469-1T(e). The form of the transaction is not relevant so that whether the governing agreement is denominated a lease or service contract will not be decisive.

The exceptions to the definition of rental activity exceed the guidelines contained in the Committee Reports. For example, Temporary regulations Section 1.469-1T(e)(3)(ii)(C) introduces a new concept of extraordinary personal services. The further definition of this new term in Section 1. 469-1T(e)(3)(v) is far too restrictive. The examples given, such as beds in a hospital, are so extreme as to provide no guidance. Why would a patient's use of a hospital bed ever raise the issue of the presence of a rental activity? This rule seems at odds with the premise of the substantial service exception that if substantial services are rendered the activity is not considered a rental activity. The regulations provide an unreasonable limitation on this concept.

The regulations provide an exception where the rental of property is incidental to a nonrental activity. Temp. Reg. Sec. 1.469-1T(e)(3)(vi). The rules then state that gross rental income must be less than 2% of the lesser of the unadjusted basis of the property or the fair market value of the property. The format of this exception should be revised. A general rule should be stated that if the rental is incidental to a non-rental activity, the holding and rental of the property will not be characterized as a rental activity. This should be a facts and circumstances test. As a safe harbor rule under this facts and circumstances test, a percentage limitation could be used. This type of approach provides a fairer and more workable standard, rather than creating a potentially costly trap for an unwary taxpayer.

Further, the 2% rule is far too strict. It is very common for taxpayers holding land for appreciation or future development to rent the property as pastureland or parking to help cover the carrying charges. The 2% rule is too restrictive. It probably does not even give taxpayers enough room to cover property taxes on many parcels of land being held for appreciation. It may force taxpayers to leave certain property idle when it could be rented.

The rigid 2% rule does not permit consideration for geographical differences, or appreciation in land. If a speculator is holding raw land for investment, the value of the land, and property taxes as well, may increase over time. The speculator may be precluded from increasing his rental charge to cover his increased property taxes without recharacterizing the nature of his loss as passive. This will hold true under this test even if the next income or loss from the activity remains unchanged.

The exceptions provided for determining whether property is held for investment or used in a trade or business both rely on a test that the gross rental income from the property cannot exceed 2% of the lesser of the adjusted basis of the property or the fair market value of the property. Temp. Reg. Sec. 1.469-1T(e)(3)(vi)(B) and (C). This test has a number of unfair and arbitrary results in addition to the restrictive nature of the 2% threshold discussed above. As illustrated above, this rule unfairly penalizes investors holding property with a low basis. It will provide an impediment to consummating tax deferred like-kind exchanges of low basis property for land. The "lesser than" component can impose an unreasonable and costly burden on taxpayers to periodically appraise their land or other holdings.

An exception is also provided for inventory property Temp. Reg. Sec. 1.469-1T(e)(3)(vi)(D). This exception is unreasonable in the form drafted and ignores tax positions which have long been accepted. If land is rented during the year and later is sold, if it is dealer (inventory) property at the time of sale, it will not be considered rental property during that year. The tax laws have long permitted taxpayers to change the use of property from investment to inventory, and vice versa. This regulation ignores this ability to change the reasons for holding property.

Further, if such a change takes place the regulation does not recognize the change unless the property is actually sold. Thus an investor who determines that it is advantageous to subdivide and sell land will have all rental income characterized as other than passive. If, however, the investor does not actually sell the land in that year, a different result will follow. To have two different characterizations of the same transaction merely because the land is or is not sold is not reasonable.

The examples which are provided in Section 1.469-1T(e)(3)(viii) are so narrow that they provide little guidance and generally only serve to further demonstrate the excessive and unfair nature of the positions taken by the regulations. Example 1 describes the rental of photocopy equipment which includes in the rental price service. Although service calls average three times a week and require substantial labor, it is concluded that the activity is a rental activity since the rental term is more than 30 days. This example conflicts with the intent and literal reading of the Committee Reports and apparent intent of the statute. This type of active involvement, considerable expense (more than 50% of the rental(s) and so forth cannot reasonably be considered to be within Congressional intent to subject it to passive loss limitations.

Example 2 reaches the opposite result because the rental period does not exceed 30 days. The different results between examples 1 and 2 cannot reasonably be reconciled. Nor can the difference reasonably promote a fair application of the passive loss rules. In comparing the two examples the concept of lease options and renewals must be raised. If a series of rules (analogous to Code Section 178) is not formulated, then taxpayers will simply begin structuring many relatively short term leases as 30 day leases with endless renewal options. Another problem is also raised. If the lessor leases property on a monthly basis, is the result going to differ depending on whether it is a 30 day or 31 day month?

Example 6 describes a scenario where land is rented, generally for an amount which does not violate the 2% rule. However in one year the landowner is fortunate enough for a movie production company to rent his land for a filming at a nominal amount which does, however, violate the 2% rule. The regulation has the character of the income or loss from the activity change for the one year because of the unusual, unexpected and nonrecurring rental by a movie production company. Although the taxpayer's involvement with the property and principal purpose for holding the property remain constant the character of the property changes. This result is inequitable because it makes planning impossible. There is absolutely no theoretical basis for making this type of arbitrary distinction.

SALE OF RENTAL PROPERTY FORMERLY USED IN A BUSINESS OR OTHER ACTIVITY

This regulation creates unreasonably difficult standards which can have arbitrary results. Further, these standards can be required to be applied in situations which are not abusive and thus result in excessive recordkeeping and calculations when a more broadly drafted rule could provide adequate protection.

EXAMPLE: A developer identifies a warehouse in a downtown area which is suitable for redevelopment as a shopping mall. The owner of the warehouse has based his construction business there for many years. He is willing to relocate and let the developer renovate the property if he can also obtain an interest in the venture. The warehouse owner contributes the property to a joint venture in which he and the developer will renovate and then lease the property. After leasing the property for six months, the developer and former warehouse owner sell the shopping mall. Since they have sold a rental property it would appear that the gain should be passive. This could be important to the developer since he may have considerable passive losses from other rental properties which should offset this income to measure his net income from his rental activity. Unfortunately, even though it is a rental property, the regulations require that when he sells an asset which was used in more than one activity during the preceeding 12 months he must make an allocation. Temp. Reg. Sec. 1.469-2T(c)(2)(ii).

How should the allocation be made? The regulations suggest than any reasonable method be used. However, the recommended approach is to allocate based on the number of months the property was used in each activity. What happens if all the appreciation in the warehouse occurred before it was converted to a rental property? Will an appraisal be sufficient to satisfy the "reasonable" test? If the warehouse was used by its prior owner for six months in his construction business and was rented as a shopping center for six months, then half of the gain would be active and half of the gain would be passive. A number of issues are, however, left unclear by this rule. Must the developer who never used the property as a warehouse have a portion of his gain treated as active? What if the renovation took four months to complete. How is the renovation time characterized? As passive (i.e. the ultimate use), as active until the character of the property is changed (its prior use), or should the construction period not be considered in the computations? The use of the warehouse has changed completely as a result of its renovations as a shopping center. This raises the issue as to whether it even makes sense to apply this rule. All of the gain may be attributable to the change in use. If the rule does apply, how should the allocation be made? It would seem that much of the gain on the sale would be due to the renovation and repackaging of the property.

This allocation rule could also be triggered in other situations, such as the change in use of an on-site management office. For example, a developer maintains an office in a shopping center where active leasing and management activities are conducted. The mall has done so well that the developer converts the office space into a store and moves the leasing and management operations to another location. If the developer sells the shopping center, allocation may have to be made under the regulations. This is in part because the regulations' de minimis rule is too narrowly drafted. The regulations state that if the value of the property for which the use changed does not exceed the lesser of 10% of the fair market value of all of the property in the activity (a reasonable standard) or $10,000, then no allocation has to be made. The $10,000 amount destroys the value of the de minimis rule and creates additional recordkeeping for unnecessary situations.

GAINS FROM DEVELOPING SHOPPING CENTERS

The Conference Committee report for the Tax Reform Act of 1986 indicated that renting real estate will generally be a passive activity. However, the development of real estate, if the developer materially participates in the development process, will generate active income. For a typical ICSC developer who develops a shopping center, then owns and leases it, this presents a problem. If the center is sold, how should the gain be characterized? Is it active income from development, or is it passive income from the sale of rental property? If the developer could be removed from the ambit of the passive loss rules by a reasonable application of the substantial services test, this conundrum would not arise. The regulations provide that if a taxpayer materially participates in the development process and then enters into a binding contract to sell the property within 24 months "after rental of the property commenced", the gain will not be passive, rather it will be active. Temp. Reg. Sec. 1.469- 2T(f)(5).

This rule raises a number of questions and problems. First, it assumes that the development of the property is the only value adding activity. Leasing and marketing are clearly activities that can enhance the value of many rental properties. If the developer is active in the development operation but doesn't participate in the leasing or marketing the property, the above rule provides an inequitable result. Further, when has the rental of a property "commenced"? A developer may have obtained a commitment from an anchor tenant long before the construction process began. Does that constitute the "commencement" of rental? Or does this rule require that a tenant actually occupy the premises and begin paying rent? How much of a property must be rented before rental commences and the tolling of the two year period starts?

For a developer who has passive losses from other rental properties, this result could impose an unfair tax burden, by taxing a portion of his business while his total net income from his business is a lesser amount. This scenario is more likely to hurt the smaller or newer developer who may not have the holding power of a larger developer to wait out the two year period.

ICSC appreciates this opportunity for submitting comments and hopes that they are of use to you.

Respectfully submitted,