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RENTAL ACTIVITIES

(a) GENERAL RULE

Rental activities are expressly defined as passive activities, regardless
of whether the taxpayer materially participates in the activity. <50> An
activity generally is considered a rental activity if payments are
received principally for the use of tangible property.

The regulations provide a more detailed definition. An activity is a
rental activity for a taxable year if: (1) during such taxable year,
tangible property held in connection with the activity is used by
customers or held for use by customers, and (2) the gross income of the
activity represents (or, in the case of an activity in which property is
held for use by customers, the expected gross income from the activity
will represent) amounts paid or to be paid principally for the use of such
tangible property. Reg. Section 1.469-1T(e)(3)(i). It is not relevant
whether the use of the property by customers is pursuant to a lease or
pursuant to a service contract or other arrangement that is not
denominated as a lease. Reg. Section 1.469- 1T(e)(3)(i).


OBSERVATION: Some activities that involve the receipt of payments for
the use of tangible property are not treated as rental activities,
generally because significant services are rendered in connection
with the use of property. Note that an activity excluded from the
definition of rental activity may nevertheless be a passive activity.
The exclusions serve only to prevent automatic treatment as a passive
activity. Once excluded, the taxpayer must still satisfy the material
participation standard.

The regulations describe the situations in which an activity involving the
use of tangible property is not a rental activity. These situations are
described in Section 50.7(b).


(b) EXCEPTIONS

The following sections describe the situations in which an activity
involving the use of tangible property is not a rental activity.


(b)(1) Seven-day or less rule

An activity involving the use of tangible property is not a rental
activity for any taxable year in which the average period of customer use
is seven days or less. Reg. Section 1.469-1T(e)(3)(ii)(A). The average
period of customer use for property held in connection with an activity
is the sum of the average use factors for each class of property held in
connection with the activity.


(b)(2) 30-day or less rule

An activity involving the use of tangible property is not a rental
activity for any taxable year if the average period of customer use is 30
days or less, and significant personal services are provided by or on
behalf of the owner of the property in connection with making the property
available for use by customers.

Significant personal services include only services performed by
individuals and do not include excluded services (as defined below).
Reg. Section 1.469-1T(e)(3)(iv)(A). In determining whether personal
services provided in connection with making property available for use by
customers are significant, all of the relevant facts and circumstances
are to be taken into account. These include the frequency with which
services are provided, the type and amount of labor required to perform
the services, and the value of the services relative to the amount
charged for the use of the property. Reg. Section 1.469-1T(e)(3)(iv)(A).
If the value of the service is less than 10 percent of the rent paid,
the service provided is not considered attributable to the amount charged
for the use of the property and is not a significant personal service.
See Reg. Section 1.469-1T(e)(3)(viii), Example (4).

Services that are excluded from the definition of significant personal
services include:

(1) services necessary to permit the lawful use of the property;

(2) services performed in connection with the construction of
improvement to the property, or in connection with repairs that
extend the property's useful life for a period substantially longer
than the average period for which the property is used by customers;
and

(3) services provided in connection with the use of improved real
property that are similar to those commonly provided in connection
with long-term rentals of high-grade commercial or residential real
property (e.g., cleaning and maintenance of common areas, routine
repairs, trash collection, elevator service, and security service at
entrances or perimeters). Reg. Section 1.469-1T(e)(3)(iv)(B).


EXAMPLE: Charles owns and operates a residential apartment hotel. For
the taxable year, the average period of customer use of the
apartments exceeds seven days, but not 30 days. Services to residents
include cleaning public entrances, exits, stairways, and lobbies, and
collecting and removing trash. These services are excluded services
because they are services similar to those commonly provided in
connection with long-term rentals of high-grade residential real
property. Charles also provides a daily maid and linen service at no
additional charge. The value of the maid and linen service (measured
by the cost of employees performing these services) is less than 10
percent of the rent charged to tenants. Under these facts,
significant personal services have not been provided in connection
with making apartments available for use by customers. Therefore, the
activity is a rental activity.


(b)(3) Extraordinary personal services provided

An activity involving the use of tangible property is not a rental
activity for any taxable year if extraordinary personal services are
provided by or on behalf of the owner of the property in connection with
making such property available for use by customers (without regard to the
average period of customer use). Reg. Section 1.469-1T(e)(3)(ii)(C).
Extraordinary personal services are provided only when the customer's
use of the property is incidental to the receipt of the services (e.g.,
receipt of personal services provided to a patient in a hospital, or
dormitory use by a student at a boarding school). Reg. Section
1.469-1T(e)(3)(v). As with significant personal services, the
extraordinary personal services must be performed by individuals. Reg.
Section 1.469-1T(e)(3)(v).

EXAMPLE 1: Frank transports goods for customers. In conducting this
activity, Frank provides the tractor-trailers pursuant to
arrangements under which he selects the tractor-trailers, may replace
them at his sole option, and employs drivers and mechanics to operate
and maintain the trucks. The average period of customer use for the
tractor-trailers exceeds 30 days. The use of the tractor-trailers by
Frank's customers is incidental to their receipt of personal services
provided by Frank (i.e., the operation and maintenance of the tractor-
trailers). Thus, the services performed are extraordinary personal
services and the activity is not a rental activity.

EXAMPLE 2: Jan is engaged in the activity of leasing photocopying
equipment. The average period of customer use for the equipment
exceeds 30 days. Pursuant to the lease agreements, skilled
technicians employed by Jan maintain the equipment and service
malfunctioning equipment for no additional charge. Service calls
occur frequently (three times per week on average) and require
substantial labor. The value of the maintenance and repair services
(measured by the cost of the employees performing these services)
exceeds 50 percent of the amount charged for the use of the
equipment. The services performed by individuals are provided in
connection with the use of the photocopying equipment, but the
customers' use of the photocopying equipment is not incidental to
their receipt of the services, i.e., Jan provides photocopying
equipment and the services provided are incidental to the customers'
use of the equipment. Thus, extraordinary personal services are not
provided in connection with making the photocopying equipment
available for use by the customers and the activity is a rental
activity.

EXAMPLE 3: The facts are the same as in Example 2, except that the
average period of customer use for the photocopying equipment exceeds
seven days, but does not exceed 30 days. Under these facts,
significant personal services are provided in connection with making
the photocopying equipment available for use by customers and, as a
result, the activity is not a rental activity.

EXAMPLE 4: A limited partnership manages a retirement center. The
retirement center provides its residents with the following
amenities: (1) three meals a day; (2) tray service to the residents'
apartments; (3) weekly maid service; (4) weekly laundering of bed and
bath linens; (5) on- and off-site recreational activities; (6) all
utilities; (7) personal laundry facilities at no extra charge; and
(8) transportation to town, doctors, and shopping. However, no
medical care is provided by the retirement center. The monthly
payments by residents is more than twice the cost of a luxury
apartment. The gross income attributable to the operation of the
retirement center represents amounts paid principally for services
rather than for the use of tangible property. Thus, the retirement
center is not a rental activity.

The IRS has advised that transportation services, including the use of an
airplane, provided by a taxpayer were extraordinary personal services, so
that losses incurred in providing the services did not constitute passive
losses from a rental activity. The dominant element of the contract
between the taxpayer and a client was the taxpayer's provision of
transportation for the client’s personnel, not the rental of the plane.
TAM 199949036.


(b)(4) Rental of property incidental to a non-rental activity

An activity involving the use of tangible property is not a rental
activity in any taxable year if the rental of such property is treated as
incidental to a non-rental activity of the taxpayer. Reg. Section 1.469-
1T(e)(3)(ii)(D). The rental of property held for investment will be
treated as incidental to the investment activity only if: (1) the
principal purpose for holding the property during the taxable year is to
realize gain from the appreciation of the property; and (2) the gross
rental income from the property for the taxable year is less than 2
percent of the lesser of (i) the unadjusted basis of such property, or
(ii) the fair market value of the property. <57> Unadjusted basis is the
adjusted basis of the property determined without regard to any
adjustment described in Code Section 1016 that decreases basis. Reg.
Section 1.469-1(e)(3)(vi)(E).

The rental of property during a taxable year is treated as incidental to a
trade or business activity only if:

(1) the taxpayer owns an interest in such trade or business activity
during the taxable year;

(2) the property was predominantly used in the trade or business
during the taxable year (or during at least two of the five
immediately preceding taxable years); and

(3) the gross rental income from the property for the taxable year is
less than 2 percent of the lesser of the unadjusted basis of such
property, or the fair market value of the property.

The provision of lodging to an employee, or to his spouse or dependents,
is treated as incidental to the activity (or activities) of the employer
taxpayer in which the employee performs services if the lodging is
furnished for the taxpayer's convenience (within the meaning of Code
Section 119). Reg. Section 1.469-1(e)(3)(vi)(D).

EXAMPLE 1: Colleen owns 1,000 acres of unimproved land with a fair
market value of $350,000 and an unadjusted basis of $210,000. She
holds the land for the principal purpose of realizing gain from
appreciation. To defray the costs of carrying the land, she leases
the land to a rancher, who uses the land to graze cattle and pays
rent of $4,000. The gross rental income from the land is less than 2
percent of the lesser of the fair market value or the unadjusted
basis of the land (2 percent x $210,000 = $4,200). Accordingly, the
rental of the land is not a rental activity because the rental is
treated as incidental to the activity of holding the property for
investment.

EXAMPLE 2: In 1996, Marcus acquires vacant land for purposes of
constructing a shopping mall. Before commencing construction, he
leases the land under a one-year lease to an automobile dealer, who
uses the land to park cars held in its inventory. Marcus commences
the construction of the shopping mall in 1997. Marcus acquired the
land for the principal purpose of constructing the shopping mall, not
to realize gain from the appreciation of the property. Thus, the
rental of the property in 1996 is not incidental to the activity of
holding the property for investment, nor has Marcus used land in any
taxable year in a trade or business. Therefore, the rental of the
property in 1996 is not treated as incidental to a trade or business
activity. Since the rental of the land in 1996 is not treated as
incidental to a non-rental activity of Marcus, the rental of the land
in 1996 is a rental activity.

EXAMPLE 3: Gerard, a calendar year taxpayer, owns farmland that was
used in a farming activity in 1993 and 1994. The fair market value of
the farmland is $350,000 and its unadjusted basis is $210,000. In
1995, 1996, and 1997, Gerard continues to own the land, but does not
use it in the farming activity. In 1995, he leases the land for
$4,000 to a rancher who uses the land to graze cattle. In 1996, he
leases the land for $10,000 to a film production company that uses
the land to film scenes for a movie. In 1997, he again leases the
land for $4,000 to the rancher.

For 1995 and 1997, Gerard owns an interest in a trade or business
activity, and the farmland he leases to the rancher has been used in
the farming activity for two out of the five immediately preceding
taxable years. In addition, the gross rental income from the land
($4,000) is less than 2 percent of the lesser of the fair market
value or the unadjusted basis of the land (2 percent x $210,000 =
$4,200). Accordingly, Gerard's rental of the land is treated as
incidental to his farming activity, and is not a rental activity.
Because Gerard's gross rental income from the land for 1996 ($10,000)
is not less than 2 percent of the lesser of the fair market value or
the unadjusted basis of the land, his rental of the land in 1996 is
not treated as incidental to the farming activity. Thus, the activity
is treated as a rental activity for 1996.


(b)(5) Non-exclusive customer use

An activity involving the use of tangible property is not a rental
activity for any taxable year if the taxpayer customarily makes the
property available during defined business hours for nonexclusive use by
various customers. Reg. Section 1.469-1T(e)(3)(ii)(E).

EXAMPLE: Mona operates a golf course. Some customers of the golf
course pay green fees for each round, while other customers purchase
weekly, monthly, or annual passes. The golf course is open to all
customers from sunrise to sunset every day of the year, except
certain holidays and days when Mona determines that the course is too
wet for play. Mona thus makes the golf course available during
prescribed hours for nonexclusive use by various customers.
Accordingly, she is not engaged in a rental activity, without regard
to the average period of customer use for the golf course.


(b)(6) Property made available for use in a non-rental activity of a
pass-through entity

An activity involving the use of tangible property is not a rental
activity for any taxable year if the taxpayer provides the property for
use in an activity conducted by a partnership, S corporation, or joint
venture in which the taxpayer owns an interest. Reg. Section 1.469-
1T(e)(3)(ii)(F). The entity must be engaged in an activity other than a
rental activity. Reg. Section 1.469- 1T(e)(3)(vii).

Where an owner provides property for use by an entity, the owner's
distributive share of the income from the entity is not treated as rental
income for purposes of the passive loss rules. For example, if a partner
contributes the use of property to a partnership, none of the partner's
distributive share of partnership income is from a rental activity unless
the partnership is engaged in a rental activity. In addition, where the
entity is a partnership and the owner receives guaranteed payments for use
of the property under Code Section 707(c), the guaranteed payments
received are not treated as income from a rental activity. Whether the
property used in the activity is provided by a taxpayer in the taxpayer's
capacity as an owner of an interest in the entity is based on all the
facts and circumstances. Reg. Section 1.469-1T(e)(3)(vii).


EXAMPLE: Alfred makes farmland available to a tenant farmer pursuant
to an arrangement designated as a crop-share lease. Under the
arrangement, the tenant is required to use her best efforts to farm
the land and produce marketable crops. Alfred is obligated to pay 50
percent of the costs incurred in the activity (without regard to
whether any crops are successfully produced or marketed) and is
entitled to 50 percent of the crops produced (or 50 percent of the
proceeds from marketing the crops). Alfred is treated as an owner of
an interest in the joint venture who has provided the farmland for
use in a farming activity conducted by the joint venture.
Accordingly, Alfred is not engaged in a rental activity, regardless
of whether he performs any services in the farming activity.


(c) SPECIAL RULES

(c)(1) Rental activities of certain real estate professionals

The passive activity loss rules provide relief from the rule that all
rental activities are passive activities for certain real estate
professionals. <61> Under Code Section 469(c)(7), the rental real estate
activities of qualifying taxpayers are not subject to the rule that
treats all rental activities as passive. Thus, a rental real estate
activity of a qualifying taxpayer is not passive if the taxpayer
materially participates in the activity. Further, Code Section 469(c)(7)
provides that each of a qualifying taxpayer's interests in rental real
estate is treated as a separate activity, unless the taxpayer elects to
treat all interests in rental real estate as a single activity. <62>
Note, however, that this aggregation rule will not permit a limited
partner to bootstrap himself into being considered as materially
participating in a limited partnership. Section 469(c)(7)(A).

OBSERVATION: For any taxable year in which a qualifying taxpayer
materially participates in a rental real estate activity, that
activity will be treated as a former passive activity under Code
Section 469(f) if disallowed deductions or credits are
allocated to the activity under Reg. Section 1.469-1(f)(4). Reg.
Section 1.469-9(e)(2).
Thus, the suspended loss or credit may be used to offset income from,
or tax liability allocable to, the rental real estate activity, and
any remaining loss or credit is treated as a loss or credit from a
passive activity.

To qualify under this provision, a taxpayer must satisfy two tests. First,
over one-half of the personal services performed by the taxpayer in trades
or businesses during the taxable year must be performed in real property
trades or businesses in which he materially participates. Second, the
taxpayer must perform more than 750 hours of services during the taxable
year in real property trades or businesses in which he materially
participates. In the case of married taxpayers who file a joint
return, one spouse must satisfy these requirements separately for them to
qualify for the relief provision. A real property trade or business
is any real property development, redevelopment, construction,
reconstruction, acquisition, conversion, rental, operation, management, or
leasing, or brokerage trade or business.

PRACTICE TIP: To establish qualification as a real estate
professional, a taxpayer should keep contemporaneous records of the
approximate number of hours spent on identified services over a
period of time, based, for example, on appointment books, calendars,
or narrative summaries. Uncorroborated estimates do not reliably
reflect hours devoted to real estate activities. The Tax Court has
noted that while regulations are somewhat ambivalent concerning the
records to be maintained in establishing the hours of participation
to qualify as a real estate professional, they do not allow a post-
event "ballpark guesstimate." Bailey v. Commissioner, T.C. Memo
2001-296.

The determination of whether a trade or business is a real property trade
or business is based on all the relevant facts and circumstances, and
taxpayers may use any reasonable method of applying such facts and
circumstances to make such a determination. Once a determination is
made that a trade or business is a real property trade or business, a
taxpayer may not redesignate such trade or business in subsequent taxable
years unless the original determination was clearly inappropriate or there
has been a material change in the facts and circumstances that makes the
original determination clearly inappropriate. Reg. Section 1.469-
9(d)(2).

Personal services performed as an employee are not considered services
performed in a real property trade or business unless the taxpayer is a 5-
percent owner in the business. To be a 5-percent owner, a taxpayer
must own at least 5 percent of a corporations' outstanding stock, or 5
percent of the total voting power of all the stock issued by the
corporations or 5 percent of either the capital or the profit interest of
a partnership. Code Section 416(i)(1)(B)) If an employee is not a
5-percent owner in the business at all times during the
taxable year, only the personal services performed by the employee during
the period the employee is a 5-percent owner will be treated as performed
in a real property trade or business. Reg. Section 1.469-9(c)(5).


A qualifying taxpayer can make an election to treat all of the taxpayer's
interests in rental real estate as a single rental real estate activity.
<68> This election is binding for the taxable year in which it is made and
for all future years in which the taxpayer is a qualifying taxpayer, even
if there are intervening years in which the taxpayer is not a qualifying
taxpayer. Reg. Section 1.469-9(g)(1). The election may be made in any
year in which the taxpayer is a qualifying taxpayer, and the failure to
make an election in one year does not preclude the taxpayer from making
the election in a subsequent year. In years in which the taxpayer is not
a qualifying taxpayer, the election will not have effect, and the
taxpayer's activities will be those determined under Reg. Section
1.469-4. Reg. Section 1.469-9(g)(1).

Go to sample election by real estate professional to aggregate all rental
real estate interests.

A taxpayer may revoke an election if there is a material change in the
taxpayer's facts and circumstances.

To revoke the election, the taxpayer must file a statement with the
taxpayer's original income tax return for the year of revocation. This
statement must contain a declaration that the taxpayer is revoking the
election under Code Section 469(c)(7)(A) and an explanation of the nature
of the material change. Reg. Section 1.469- 9(g)(3).

PRACTICE TIP: The election to treat all interests in rental real
estate as a single rental real estate activity is binding for the
taxable year in which it is made and for all future years in which
the taxpayer is a qualifying taxpayer, unless there is a material
change in the taxpayer's facts and circumstances. Thus, taxpayers
should make sure that the election will work in their favor. For
example, if a real estate professional is (1) a passive investor in
rental realty that is generating income (as opposed to a loss), (2) a
material participant in other realty activities generating losses,
and (3) an owner of a non-real estate passive activity that is
generating a loss, the election should not be made because the realty
income would be passive activity income that could be offset by the
non-realty passive loss. If, in this situation, the election was
made, the realty income would be treated as non-passive and could not
be sheltered by the non-realty passive loss. On the other hand, an
election would be helpful in a situation where the taxpayer owns loss-
generating rental real estate in which the taxpayer does not meet the
material participation standard separately, but would escape the
passive activity loss rules if it were combined with other material
participation properties because the taxpayer could satisfy the
material participation standard for the combined activity.

EXAMPLE: Robertson is the sole general partner in two real estate
partnerships which own and rent office buildings, and is not
connected with any other business ventures. Robertson can satisfy
the material participation requirements for both, but to satisfy the
750 hour real estate professional requirement must be able to treat
the two partnerships as a single entity. Accordingly, making the
election allows Robertson to qualify as a real estate professional
and set the losses off against regular income.

In general, a qualifying taxpayer's interest in rental real estate held by
a pass-through entity (a partnership or S corporation) is treated as a
single interest in rental real estate if the pass-through entity grouped
its rental real estate as one rental activity under Reg. Section 1.469-
4(d)(5). If the pass-through entity grouped its rental real estate into
separate rental activities under Reg. Section 1.469- 4(d)(5), each
rental real estate activity of such entity will be treated as a separate
interest. However, a qualifying taxpayer may elect under Reg. Section
1.469-9(g) to treat all interests in rental real estate, including the
rental real estate interests held through pass-through entities, as a
single rental real estate activity. Reg. Section 1.469-9(h)(1).


COMPLIANCE TIP: A partnership holding rental real estate should
attach a schedule that lists the pertinent schedule K-1 items on an
activity-by-activity basis. It is then up to each individual partner
to determine whether he meets the material participation test (or the
active participation requirements to claim the $25,000 loss
allowance) when combined with other rental real estate activities.

A qualifying taxpayer may not group a rental real estate activity with any
other activity of the taxpayer. For example, if a qualifying taxpayer
develops real property, constructs, buildings, and owns an interest in
rental real estate, the taxpayer's interest in rental real estate may not
be grouped together with the taxpayer's development activity or
construction activity.

EXAMPLE: Roberts is the sole general partner in two real estate
partnerships. ABC partnerships owns and rents office buildings. XYZ
partnerships develops and rents office buildings. Roberts performs
700 hours of services for each partnership during the partnerships'
tax year, and performs no services for any other business. Roberts
can meet the material participation requirement in either partnership
only under the 500 hour test. Both partnerships operate at a loss.

Unless Roberts performs at least 500 hours of her services at the XYZ
partnership in connection with its rental activities, the losses
incurred by both partnerships will be classified as passive losses
because she: (1) fails the material participation test for that
partnership; (2) is therefore not permitted to combine its rental
activities with the ABC partnership; and (3) does not meet the
professional real estate test for that partnership.

A special rule applies if a qualifying taxpayer holds a 50 percent or
greater interest in a pass-through entity. Under this rule, if a
qualifying taxpayer owns, directly or indirectly, a 50 percent or greater
interest in the capital, profits, or losses of a pass-through entity for a
taxable year, each interest in rental real estate held by the pass-through
entity will be treated as a separate interest in rental real estate of the
qualifying taxpayer, regardless of the pass-through entity's grouping of
activities under Reg. Section 1.469-4(d)(5). <71> However, a qualifying
taxpayer may elect under Reg. Section 1.469-9(g) to treat all interests
in rental real estate, including the rental real estate interests held
through pass-through entities, as a single rental real estate activity.
Reg. Section 1.469-9(h)(2).

The treatment of limited partnership interests in rental real estate
activities is addressed in Reg. Section 1.469-9(f). In general, if a
taxpayer elects under Reg. Section 1.469-9(g) to treat all interests in
rental real estate as a single rental real estate activity, and at least
one interest in rental real estate is held by the taxpayer as a limited
partnership interest (within the meaning of Reg. Section
1.469-5T(e)(3)), the combined rental real estate activity will be treated
as a limited partnership interest of the taxpayer for purposes of
determining material participation. Accordingly, the taxpayer will not be
treated as materially participating in the combined rental real estate
activity unless the taxpayer materially participates in the activity
under the tests listed in Reg. Section 1.469-5T(e)(2). <72> Under a de
minimis exception, the general rule does not apply if the taxpayer elects
to treat all interests in rental real estate as a single activity, and the
taxpayer's share of gross rental income from all the taxpayer's limited
partnership interests in rental real estate is less than 10 percent of the
taxpayer's share of gross rental income from all of the taxpayer's
interests in rental real estate for the taxable year. In such case, the
taxpayer may use any of the tests listed in Reg. Section 1.469-5T(a) to
establish material participation in the activity. Reg. Section
1.469-9(f)(2).

A qualified taxpayer's passive losses and credits from rental real estate
activities (including suspended passive activity losses and credits from
rental real estate activities in which the taxpayer materially
participates) are allowed to the extent permitted under Code Section
469(i). Reg. Section 1.469-9(j). Under Code Section 469(i), such a loss or
credit may be used to offset non- passive income or tax liability
attributable to non-passive income, subject to a $25,000 limitation and a
phaseout rule. The regulations also clarify that Code Section 469(i)
applies after the rules of Code Section 469(c)(7) are applied. Thus, the
$25,000 offset will be applied only against passive losses from rental
real estate activities and not against losses that are allowable as a
result of Code Section 469(c)(7). In addition, adjusted gross income for
purposes of Code Section 469(i) is not reduced by any losses from
rental real estate that are allowable as a result of Code Section
469(c)(7). Reg. Section 1.469-9(j).


(c) WORKING INTERESTS IN OIL AND GAS PROPERTY

A working interest (as defined below) in any oil and gas property that the
taxpayer holds directly or through an entity that does not limit the
liability of the taxpayer is not treated as a passive activity, whether or
not the taxpayer materially participates in such activity. <73> However,
if net losses from a working interest in a property are treated as not
being from a passive activity in one year, any net income realized by the
taxpayer from that property (or from any substituted basis property, such
as property acquired in a Code Section 1031 like-kind exchange) in any
subsequent year is also treated as not from a passive activity. <74> If
the preceding rule applies, any credits that are attributable to such
property for such taxable year are treated as non- passive credits to the
extent the amount of such credits do not exceed the taxpayer's regular
tax liability that is allocable to such net income for the taxable year.

In general, a working interest means a working or operating mineral
interest in any tract or parcel of land (within the meaning of Reg.
Section 1.612-4(a)). Reg. Section 1.469-1(e)(4)(iv). Rights to overriding
royalties, production payments, and the like do not constitute working
interests because they are not burdened with the responsibility to share
expenses of drilling, completing, or operating an oil and gas property.
Similarly, contract rights to extract or share in oil and gas, or in
profits from extraction, without liability to share in the cost of
production, do not constitute working interests. Income from such
interests is generally considered to be portfolio income and not passive
income. S. Rep. 313, 99th Cong., 2d Sess. 713, 744 (1986).

A working interest generally has characteristics such as responsibility
for signing authorizations for expenditures with respect to the activity,
receiving periodic drilling and completion reports, receiving periodic
reports regarding the amount of oil extracted, possessing voting rights
proportionate to the percentage of the working interest possessed by the
taxpayer, the right to continue activities if the present operator decides
to discontinue operations, a proportionate share of tort liability with
respect to the property (e.g., if a well catches fire), and some
responsibility to share in further costs with respect to the property in
the event that a decision is made to spend more than amounts already
contributed. S. Rep. 313, 99th Cong., 2d Sess. 713, 744 (1986). However,
the fact that a taxpayer is entitled to decline, or does decline, to make
additional contributions under a buy out, non-participation, or similar
arrangement, does not contradict the taxpayer's possessing a working
interest, nor does the fact that a venture is insured against tort
liability.

The exception to the definition of passive activity for working interests
in oil and gas property is not applicable when the form of ownership
limits the taxpayer's liability, including:

(1) a limited partnership interest in a partnership in which the
taxpayer is not a general partner;

(2) stock in a corporation; and

(3) an interest in any other entity that, under applicable state law,
limits the potential liability of the holder of the interest for all
obligations of the entity to a determinable fixed amount (e.g., the
sum of the taxpayer's capital contributions)

In the case of tiered entities, the rule is applied by looking through the
entities. S. Rep. 313, 99th Cong., 2d Sess. 713, 745 (1986). For example,
a general partner in a partnership that owns a limited partnership
interest in a second partnership is not treated as owning a working
interest, even though the second, limited partnership owns a working
interest. Conversely, a limited partnership that purchases a general
partnership interest in a working oil and gas interest will produce
passive income or losses or its limited partners. PLR 8746041.

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