A Husband & Wife (H&W) own land, on which they operate a farm.  The farm has been incorporated as a 2-person LLC.  The H&W incurred personal debt to start the business, i.e., to construct the necessary agricultural buildings, purchase farm equipment, etc. 

At the suggestion of their attorney, a Deed of Lease was executed between the H&W and the LLC, under which the LLC pays rent for use of the land, “together with all improvements thereon”.  The H&W offset this income with their Interest Expense, RE Taxes, Depreciation, etc.  There’s taxable income until the Depreciation Expense, at which point there are sizable losses. 

Question:  What is the proper way to report this?  Because I MUST be doing something wrong, or missing something!  

I thought when this was reported on the Sch E, because it was a Self-Rental, and because it was part of a Trade or Business Activity, and because the H&W operate this farm themselves, any losses from the Sch E Rental would be claimable and would be netted against the flow-through Income from the LLC, for net taxable income to the taxpayers (approx. $108,000 total net), and all would be right with the world.

Instead, the system is trying to classify all the Sch E losses as PALs and disallow them, and tax all the income from the LLC, and all is NOT right with the world. 

Absent the Lease Agreement, all that Income and Expense would have stayed in the LLC and flowed through to the T/P’s F1040, and there’d be no question of Passive anything.

The only reason ANY of this started in the first place is because all the Mortgage Loans are being reported under the T/P’s SS# and there was question/concern raised about the LLC claiming a deduction for Mortgage Interest reported under the T/P’s Tax ID# on the LLC’s F1065, and from that, grew this situation. 

The agricultural buildings and equipment are being reported as part of the rental solely because they secure the loans, and it seemed logical to keep the loans and their collateral together. 

If the agricultural buildings and equipment are reported as assets of the LLC instead of the rental, the Depreciation Expense leaves the Sch E, and with it, the losses, and the problem.

Thoughts? (and if I've missed/forgotten something basic and you're about to tell me I'm an idiot, please be gentle  😕  lol)  And sorry it's so long, I blame COVID-19!