Questions around Passive vs. Active classification of activities in my LLC.

[Andrew Angell]

I leverage my Life Insurance cash value in a couple of different ways with an LLC, and I have some questions about active vs. passive classification on the deals I'm doing.

I take a policy loan personally, and then I lend the cash to my LLC.

The LLC holds a real estate syndication which pays monthly interest only payments and provides a K1 with passive losses on the books.

I am doing private lending from this LLC as well, and I have about 12 deals going through a broker where we (as a group) are the 1st lien position on a property, and we receive monthly interest only payments as cashflow. When the principal is paid off we typically roll those funds right back into another deal.

In both cases we do nothing but send the cash and collect the monthly payments. I'm getting mixed feedback from a variety of CPA's on how these activities will be classified.

I was thinking that the private lending would be considered passive. As such, the interest income we receive from the private lending would be offset by the K1 losses from the syndication. Some CPA's have confirmed this.

Other CPA's are telling me that it would be considered active since we are "actively" lending on multiple deals in an LLC and are receiving a 1099-INT from the broker of these deals.

If that's the case, then wouldn't the syndication be considered active as well? In which case the K1 losses from the syndication would be able to offset the active private lending income as well as active income from other LLC's.

When I bring this up to the CPA's they look at me a little funny and they don't have a confident answer for me. They are now researching.

It feels to me like the IRS is trying to have their cake and eat it to. They're telling me on one hand that my LLC active, and on the other hand that the activity is passive.

I'm curious if anybody in here is doing something similar and has already filed returns or has any case law examples that would clarify how we could/should handle this.

Any information on this would be greatly appreciated. Thanks!

[Kory Reynolds]

There can be different activities within a single LLC that are classified as passive or active, for each it will depend on the nature of that activity. The classification of one activity within the LLC doesn't necessarily drive the classification of another activity in the same LLC.

For the syndication, given it is a rental activity, it would be per-se passive. It doesn't get turned into active just because you have other separate activities within the LLC. We don't get to work around the real estate professional rules just by lumping passive real estate into the same LLC as an active activity.

The lending is going to be very facts and circumstances dependent, and will likely depend on how you are going about this activity.  On one extreme if you are actively going out and advertising you have hard money to lend, working closely with investors, managing those deals, acting like a bank, etc - it could sound like you are in the trade or business of lending, making that active / potentially self-employment type income.  On the other extreme, you just happen to have a few associates in real estate that you lend money out in a revolving door and are not acting as a business in this venture - just purely a loan, then perhaps it is just portfolio interest income.  All of this also impacts the deductibility of related expenses on these lending deals (investment expense versus trade or business expense).  It is VERY facts and circumstances driven, so it is not surprising that you are receiving different answers - anywhere in the middle of the two scenarios and it will be a decision and position to be taken on the tax return.

[Troy Halsey]

great answer

[Andrew Angell]

Quote from @Kory Reynolds:

There can be different activities within a single LLC that are classified as passive or active, for each it will depend on the nature of that activity. The classification of one activity within the LLC doesn't necessarily drive the classification of another activity in the same LLC.

For the syndication, given it is a rental activity, it would be per-se passive. It doesn't get turned into active just because you have other separate activities within the LLC. We don't get to work around the real estate professional rules just by lumping passive real estate into the same LLC as an active activity.

The lending is going to be very facts and circumstances dependent, and will likely depend on how you are going about this activity.  On one extreme if you are actively going out and advertising you have hard money to lend, working closely with investors, managing those deals, acting like a bank, etc - it could sound like you are in the trade or business of lending, making that active / potentially self-employment type income.  On the other extreme, you just happen to have a few associates in real estate that you lend money out in a revolving door and are not acting as a business in this venture - just purely a loan, then perhaps it is just portfolio interest income.  All of this also impacts the deductibility of related expenses on these lending deals (investment expense versus trade or business expense).  It is VERY facts and circumstances driven, so it is not surprising that you are receiving different answers - anywhere in the middle of the two scenarios and it will be a decision and position to be taken on the tax return.

Thanks for the feedback!

I have another LLC that holds a short-term rental that is classified as active, so we did the cost-seg, bonus depreciation, etc. and we'll be offsetting a solid chunk of our active income this year.

I was hoping maybe there was some sort of similar trick here that could be used to reclassify this syndication as active based on specific facts and circumstances like you mention.  Is that sort of thing just not possible with a syndication?

Focusing on the private lending side, I did exactly the same thing I did for the syndication.  Google -> Analyze -> Research -> Invest -> Collect monthly payments.  I do nothing after that.  I'm not advertising myself as a lender, I don't work with the actual borrowers in any way, and I don't hold the note in my actual name.  

I send the cash to a middle-man company that technically holds the 1st lien position with us investors listed on Schedule A of the deed that gets filed with the county.  If a foreclosure were to occur, we all have to sign off, but the middle-man handles everything.

The LLC these are held in is a "liability safe holdings" LLC that does nothing but hold these assets as well as my taxable brokerage account. It really has no expenses.

I could easily do some advertising if that help re-classify the syndication as active, by chance, or I could do whatever I need in order to classify the private lending as passive.  

I lay all of this out for a variety of CPA's and I get different answers as mentioned.  There isn't much else to the facts and circumstances.

Does that info help to elaborate on what potential options I might have if I were to find a CPA (maybe you, for example) that is willing to figure all this out and do it legitimately with me?

[Kory Reynolds]

Hi Andrew - 

Taking this one at a time, for the LLC that holds a short term rental that you were able to classify as active / materially participating - there is no similar trick to use for the syndication. It works for the short term rental because of the amount of time you are putting into that activity to hit the material participation thresholds. The Syndication doesn't have this same option since you put zero working hours into it. The syndication is what it is - passive - and unfortunately there are no tricks to turn it Active in your scenario. Real estate professional status with material participation in rental activities is how one can end up having "active" syndication losses - but doesn't sound like the scenario you have.

For the lending, that to me does sound like regular old interest income - for IRS purposes portfolio / investment income, which is neither Active nor Passive - it is it's own bucket. Given you are using a loan from your life insurance policy, any interest expense paid as a result of loan proceeds that can be traced to the Lending activity could be (potentially) deducted as investment interest expense.  Any other expenses incurred related to the lending would be non-deductible lending expenses.  

The comment you have about doing some advertising to make it active - if your action has no real teeth and you are just doing it to try and meet material participation or some other kind of standards, typically the tax position itself has no teeth and would not be recommended. The action should have true economic ramifications and not just be for a tax position. Additionally, any change in status (active versus portfolio income) of your lending activity will have zero impact on the active/passive status of your syndication activity - they are still two separate activities that must be considered separately, even though they are held within the same LLC. Additionally, the change of your lending activity to active could potentially have an even worse tax impact due to potential exposure to self employment tax. Point being tax wise - the portfolio treatment of you lending and passive treatment on the syndication might not be all that bad.

[Andrew Angell]

Quote from @Kory Reynolds:

Hi Andrew - 

Taking this one at a time, for the LLC that holds a short term rental that you were able to classify as active / materially participating - there is no similar trick to use for the syndication. It works for the short term rental because of the amount of time you are putting into that activity to hit the material participation thresholds. The Syndication doesn't have this same option since you put zero working hours into it. The syndication is what it is - passive - and unfortunately there are no tricks to turn it Active in your scenario. Real estate professional status with material participation in rental activities is how one can end up having "active" syndication losses - but doesn't sound like the scenario you have.

For the lending, that to me does sound like regular old interest income - for IRS purposes portfolio / investment income, which is neither Active nor Passive - it is it's own bucket. Given you are using a loan from your life insurance policy, any interest expense paid as a result of loan proceeds that can be traced to the Lending activity could be (potentially) deducted as investment interest expense.  Any other expenses incurred related to the lending would be non-deductible lending expenses.  

The comment you have about doing some advertising to make it active - if your action has no real teeth and you are just doing it to try and meet material participation or some other kind of standards, typically the tax position itself has no teeth and would not be recommended. The action should have true economic ramifications and not just be for a tax position. Additionally, any change in status (active versus portfolio income) of your lending activity will have zero impact on the active/passive status of your syndication activity - they are still two separate activities that must be considered separately, even though they are held within the same LLC. Additionally, the change of your lending activity to active could potentially have an even worse tax impact due to potential exposure to self employment tax. Point being tax wise - the portfolio treatment of you lending and passive treatment on the syndication might not be all that bad.

 Thank you so much for laying that out I really appreciate it!

[Michael Plaks]

@Andrew Angell

The reason why you're getting contradicting answers is what @Kory Reynolds mentioned: the answers to such complex questions are case-by-case, and even if you write another dozen paragraphs describing your business, it will not be enough for any of us to have a complete picture. 

Unless you get an in-depth consultation with a tax accountant specializing in real estate, you will probably keep getting these confusing answers.

And I will add to the confusion, for my part. 1099-INTs that you receive send the IRS a signal that this is "portfolio" income which is indeed a different category of income altogether. However, when you're in the business of private lending, this portfolio income is most likely reclassified as ordinary business income. Then it can be passive or nonpassive (no such thing as "active") depending on your material participation. So, under specific circumstances, you might be able to offset income from passive lending with syndication losses. 

No, there are no tricks but also no quick black-and-white answers, sorry. A very complex situation that requires an in-depth case-by-case analysis.

[Andrew Angell]

Quote from @Michael Plaks:

@Andrew Angell

The reason why you're getting contradicting answers is what @Kory Reynolds mentioned: the answers to such complex questions are case-by-case, and even if you write another dozen paragraphs describing your business, it will not be enough for any of us to have a complete picture. 

Unless you get an in-depth consultation with a tax accountant specializing in real estate, you will probably keep getting these confusing answers.

And I will add to the confusion, for my part. 1099-INTs that you receive send the IRS a signal that this is "portfolio" income which is indeed a different category of income altogether. However, when you're in the business of private lending, this portfolio income is most likely reclassified as ordinary business income. Then it can be passive or nonpassive (no such thing as "active") depending on your material participation. So, under specific circumstances, you might be able to offset income from passive lending with syndication losses. 

No, there are no tricks but also no quick black-and-white answers, sorry. A very complex situation that requires an in-depth case-by-case analysis.

 I appreciate the feedback.  Just another example of more conflicting info, though, as you're telling me it's possible while @Kory Reynolds says it's not, and you both seem to have tax credentials.

I work with Anderson Advisors, who is supposed to be tax / real estate specialists, yet when I speak to different people within their group I get different answers.

I've talked with KKOS Attorneys (Mark Kohler) who is also tax attorney that specializes in real estate, and again, I get conflicting answers.

I talk to local CPA's and attorneys who yet again give me conflicting answers.

Do I just pick the one that says it can be done and make sure they'll back me up with some sort of audit protection, or what do people do when they HAVE spoken to the "specialists" and keep getting different answers?

[Michael Plaks]

@Andrew Angell

You're restating what I already told you: you will continue to receive conflicting information if your conversations are short or you're talking to less experienced people. While the founders of Anderson and KKOS are very knowledgeable, the people in their organizations who you actually talk to are not necessarily so.

[Sean O'Keefe]

Quote from @Michael Plaks:

@Andrew Angell

The reason why you're getting contradicting answers is what @Kory Reynolds mentioned: the answers to such complex questions are case-by-case, and even if you write another dozen paragraphs describing your business, it will not be enough for any of us to have a complete picture. 

Unless you get an in-depth consultation with a tax accountant specializing in real estate, you will probably keep getting these confusing answers.

And I will add to the confusion, for my part. 1099-INTs that you receive send the IRS a signal that this is "portfolio" income which is indeed a different category of income altogether. However, when you're in the business of private lending, this portfolio income is most likely reclassified as ordinary business income. Then it can be passive or nonpassive (no such thing as "active") depending on your material participation. So, under specific circumstances, you might be able to offset income from passive lending with syndication losses. 

No, there are no tricks but also no quick black-and-white answers, sorry. A very complex situation that requires an in-depth case-by-case analysis.

Hard to beat this answer

[Kory Reynolds]

Quote from @Michael Plaks:

You're restating what I already told you: you will continue to receive conflicting information if your conversations are short or you're talking to less experienced people. While the founders of Anderson and KKOS are very knowledgeable, the people in their organizations who you actually talk to are not necessarily so.

@Andrew Angell To this point - there may be cases where you have perceived inconsistencies, but it may just be your interpretation or different language being used to describe that situation.  To Michael's point, I did use the incorrect language in my post - I should have been discussing Passive vs Nonpassive, rather than using the word "active" as a replacement for nonpassive.

I'm not sure what I said you can do that is in contradiction to what Michael commented, but I believe we both described the baseline in a similar manner, and Michael by using the more accurate language.  He did expand further upon it another scenario that could apply that I did not discuss, but was not contradictory to my statement - if your lending is a trade or business (not portfolio), but is also passive, syndication losses could offset it.

In short...Michael is much better at being concise than I am, but I don't find anything that I would disagree with in his post (or any other post that he makes) - I find he is typically spot on.

[Michael Plaks]

The most recent comments on this thread by @Kory Reynolds are reinforcing the same message that has been stated several times already:

With questions as complex as yours, @Andrew Angell, you cannot distill it to some simple rule, such as "this is passive, and this is not, so they are not in the same bucket." The correct answer will be much longer and, most importantly, conditional on your specific circumstances. Aka "it depends."

And sometimes there is no one correct answer at all. You might have multiple (and conflicting) answers, subject to interpretation. 

I also wish the tax rules were much simpler than they are, but they are not simple.

[John Malone]

@Andrew Angell as the others mentioned, there is probably more specifics needed BUT interest income would be considered Portfolio income vs passive (or nonpassive) income unless you materially participating in this activity.

From these facts, I can’t see the interest being treated as passive though