Are ATM Investments Passive or Non-Passive?

A couple of months ago, a client approached us at The Real Estate CPA (our tax firm) and was excited to tell us about this new investment opportunity that would eliminate their tax bill.

They explained it as being similar to a real estate syndication in that they invest some amount of money and, in return, own a stake in the partnership. The partnership then allocates income and losses to the investor based on whatever is written in the operating agreement.

But this syndication was different. Instead of investing in a partnership that invests in real estate, the partnership was investing in ATM machines.

And because the useful life of an ATM is less than 20 years, the cost of the ATM can be 100% bonus depreciated.

As it was explained to our client, this would create a large business loss that would offset their W-2 income.

Luckily, we have seen many ATM syndicates over the years as we have worked with 1,000s of real estate investors.

Though this was not new territory for us, we ultimately had the responsibility of being the bearer of bad news.

How ATM Syndicates Report Income/Losses

When you invest in an ATM syndicate, you will receive a Form K-1 that will summarize your share of the partnership activity. The net profit or loss will be reported in Box 1 on Form K-1.

When an ATM syndicate is buying ATM machines, they will incur large amounts of bonus depreciation expense. This will generally create a taxable loss that is then allocated to investors.

It’s common for an investor in a new ATM syndicate to see a large loss allocated to them in Box 1 on Form K-1.

Here’s why people get tripped up: Box 1 is where you report “Ordinary Income or Loss” from the partnership activities. When investors and sponsors alike see the word “ordinary” they think that any loss allocation can offset W-2 or other business income.

But it’s not that simple.

When income or loss is reported in Box 1, we have to apply the passive activity rules to determine if it’s a passive or non-passive activity. And if we determine that the loss is passive, then it cannot offset W-2 income because W-2 income is non-passive.

The Passive Activity Rules in a Nutshell

IRC Sec. 469 says that two activities are passive: (1) all rental activities unless you qualify as a real estate professional; and (2) any business in which you do not materially participate.

For the purposes of an ATM syndicate, we’re analyzing the second type of activity.

So what does material participation mean?

First, you must pass the qualitivate test by participating on a regular, continuous, and substantial basis.

Second, you must pass one of the qualitivate tests found in Treas. Regs. Sec. 1.469-5T:

1. Participate in the activity for more than 500 hours during the year.
2. Participation in the activity is substantially all of the participation in the activity of all individuals for the year.
3. Participate in the activity for more than 100 hours during the taxable year, and more than anyone else.
4. The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
5. The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year.
6. The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Most likely as an investor in a syndicate you will be unable to pass any of these seven tests. And that simply means that any losses passed back to you from the partnership, regardless of how they are reporte on your Form K-1, are passive losses.

Passive losses can only offset passive income. They cannot offset your non-passive income like W-2, business, interest and dividend income as well as gain on any stock sale.

Takeaways

Investors may run across sponsors of syndicates who do not fully understand the passive activity rules. As a result, these sponsors will unentionally promise tax benefits that can not be acheived.

It is important for investors to understand the passive activity rules and more specificalyl the material participation tests. Whether or not you materially participate in the activity will determine how you can treat the income or loss on your personal return.