Self-Rental Rules | The Grouping Election
By Mahoney
What is a Self-Rental?
Many taxpayers who own an operating business also own accompanying real estate inside a separate entity. The operating business then leases the real estate from the entity that owns it. This is known as a “self-rental” agreement. When taxpayers find themselves in this situation, IRC Section 469 requires the income to be subject to “the recharacterization” rules.
Treatment of Income and Losses from Self-Rentals
Under the self-rental recharacterization rules, income from a self-rental is treated as nonpassive, while losses are treated as passive. This treatment means that any income produced by a rental entity to which the self-rental rules apply cannot be netted against passive losses from other rental entities. This rule prevents a taxpayer from being able to “create” passive income from an active business in which tangible property is used by renting the property to a separate entity owned by the same taxpayer.
Here is an example that illustrated the self-rental rules:
Individual B is a passive investor in a limited partnership that allocated to B a $30,000 loss. Individual B can only utilize a loss if he has passive income from other sources. In an attempt to generate other passive income, individual B rents a building he owns personally to an S corporation in which individual B materially participates, generating $30,000 of rental income.
Although rental activities are generally considered passive under the rules of Section 469, the self-rental rules take over in this example to treat Individual B’s rental income as nonpassive. As a result, Individual B cannot offset the $30,000 of passive loss from his limited partnership interested with the $30,000 of nonpassive income from the self-rental.
Additionally, a taxpayer must pay special attention to the rental rate charged between their operating business and their rental property entity. If the rent charged is too low and produces a rental loss, the resulting loss becomes passive and may be suspended if the taxpayer has no other passive income.
Tax Planning Items of Consideration for Self-Rentals
Without the proper tax planning, the self-rental rules can impose an unexpected burden on taxpayers. A taxpayer expecting to use income from a self-rental activity to offset passive losses from other sources could be faced with a much higher tax liability than expected. Although the self-rental rules can cause an unexpected burden to taxpayers, there are also opportunities that can be utilized with the proper tax planning.
For example, if a taxpayer regularly has passive incomes from other sources that can be used to offset passive losses, the self-rental rules may benefit the taxpayer. In this case, since the self-rental income is considered nonpassive, it would not be subject to the net investment income tax (NIIT). Since the income from the rental entity can be easily controlled by the taxpayer, identifying opportunities such as this one can allow the taxpayer to benefit from the self-rental rules.
The Grouping Election
Taxpayers engaged in a self-rental activity may consider a grouping election to pair the self-rental activity with the operating entity. This grouping election would allow taxpayers to combine what would be a passive loss from a self-rental activity with income from an operating entity. In order to group activities under IRC 469, the activities must constitute an appropriate economic unit for measuring gain or loss and:
- The rental activity is insubstantial in relation to the trade or business activity;
- The trade or business activity is insubstantial in relation to the rental activity, OR;
- Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.
If all of the requirements are met to group the activities, the grouping election is particularly beneficial if a taxpayer does not have any passive income from other sources. When the grouping election is made, a taxpayer must continue to use the grouping established unless there is a material change to the facts and circumstances.
The self-rental rules present a complicated challenge for many taxpayers. For additional questions or considerations, please reach out to Travis Koester, Senior Associate, or contact our Tax Solutions Team at Mahoney to be of help to you in any way.
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