Against More Dues To The Treasury: Self-Rental Rules
As a real estate investor you may be aware of the passive and nonpassive rules for rental real estate, i.e. passive income can only be offset against passive income, and nonpassive income (active participation) can only be offset with nonpassive losses. Section 469 of the Internal Revenue Code classifies rental activity as a passive activity, unless certain tax code parameters are met, such as an active real estate professional with more than 500 hours of participation in the activities per year.
Say as a real estate investor you own two commercial properties rented to unrelated businesses. Property 1 produces net passive income of $25,000, and Property 2 produces a passive loss of $15,000. Your taxable income on the two rental properties would net to $10,000. If you decide to rent Property 1 to your business, you are now subject to self-rental rules.
Q: What is a self-rental? A: Renting real estate to a business or trade you materially participate in. Self-rental rules classify rental income as nonpassive; and rental losses as passive. Instead of both income and losses as passive, typical in most real estate rentals, self-rental has passive losses and nonpassive income. So in the example above, with the financial performance of the real estate comparable on the self-rental, the $25,000 of self- rental income would be nonpassive revenue, and the $15,000 of loss on Property 2 would still be passive. Now you would pay tax on the $25,000 from Property 1, and have a suspended loss of $15,000 from Property 2. The $25,000 of income can be offset by suspended passive losses from the activity of that property, but cannot be offset from other activities, such as Property 2 or additional rental estate you purchase. So, you can see that self-rental rules can result in unfavorable tax costs, i.e. suspended losses and more tax.
If you sell your business, in this example located in Property 1, and maintain ownership and continue to rent the real estate of Property 1, you will still be subject to self-rental rules after the business is sold. This is the 5 out of 10 year rule. This rule requires for a period of at least five years from the sale of the business, you will be continue to be subject to self-rental rules for that property.
CPA’s can resolve this quandary on your tax filing, with proper planning if involved in your real estate decision making. The tax planning in this instance involves an aggregation election of the activities. However, the aggregation election can only occur in the first year the taxpayer reports the activity, and requires an election with an attached formal statement to your tax filing. An aggregation permits you to consolidate for tax purposes your business activity and rental activity, together into a material participation unit. This provides a tax benefits because the real estate income or losses are consolidated as nonpassive activities. So you could have a $40,000 loss on Property 1, aggregate the activity with your business, and deduct the $40,000 loss against say $50,000 of business income, and pay tax on only $10,000 net, from the two activities.
Summary: Self-rental rules come into play in instances with real estate rented to a business a taxpayer materially participates in. Self-rental rules can result in unfavorable higher tax costs. Talk with your CPA before buying, or building, a real estate portfolio for appropriate tax planning.