Question: I as a business owner personally own property, that is being rented to my business. As a result of owning that building, I have a loss due to all the costs I’m incurring to own and maintain that building. All of these costs result in a loss, that I currently cannot use to offset my income. I’d like to be able to deduct that “passive loss”, to offset the tax that I am currently pay on my “active income”. Can I do that, and if so, how do I do it?
Answer: If you are working full-time (or, like many of our clients, MORE than full-time) in a business, that is unrelated to rental real estate, and you own rental real estate, it is nearly impossible to classify your real-estate-related activity as an “active” trade or business. Put simply, an “active” business is one in which you “materially participate”. Although the amount of time and effort you put into your rental business might feel like a full-time job, in the above-described circumstance, the IRS has almost monolithically characterized your toil as “passive” and not “active”.
What are the tax implications of having your business classified as “passive”?
Well, for starters, passive gains and passive losses can only offset one another. As such, passive losses cannot be used to offset “active” business income. For those with high active income, this limitation frequently produces an undesirable result. For example, if you own 3 rental properties that produce an aggregate passive loss of $50,000 due to expenses (depreciation is most frequently the largest of those expenses) and you have $500,000 of income from your active business, you will not be able to reduce your $500,000 active business income by the $50,000 passive loss. Unless you have other passive gain, the $50,000 excess passive loss cannot be deducted in that specific tax year. Instead, the passive loss would be “carried forward” to the following tax year where the loss can only be used to reduce future passive income.[i]
One notable exception to the general rule that all rental activities (as described above) are de jure´ passive is the “self-rental rule.” IRC §469 and, in particular, Treas. Reg. §1.469-2(f)(6), includes a self-rental provision that transforms income from a taxpayer’s rental activity into active income if the property is rented for use in a trade or business activity in which the taxpayer materially participates. In that circumstance, the rent paid by the operating business to the rental business is deducted from the active income of the operating business and, coincidentally, any expenses of the rental business can be used to reduce that (now) active rental income. Of course, the obverse is, because income in that circumstance has been recharacterized as “non-passive” through Congressional fiat, it can no longer offset passive losses, but solely active income.
For clients focused on reducing active business income, the self-rental rule can be a simple, yet effective, way to accomplish that objective. The most common self-rental structure involves a business owner renting real estate that he or she owns to a business that he or she also owns. Typically, the real estate is not owned in the operating business. The real estate entity is most often an LLC that is either taxed as partnership, an S corporation or, perhaps, a disregarded entity (reported on Schedule C) for income tax purposes. As you might have surmised, by logical extension, the self-rental rule also applies to leasing companies and other entities where the owner of the leasing company leases property to a business in which the owner materially participates.
Seems like a pretty straightforward exception, right?
Well, as Tax Code Plot Lines go, this one has a couple of interesting Twists…
Plot Twist #1: With self-rented property, the rule only applies if net income results. In other words, if the rental activity produces a loss, it remains a passive loss. Consequently, the amount of rent paid becomes a critical variable in this equation. Obviously, if the rental income is insufficient to “match up” with the amount of depreciation (and other expenses) taken and, ultimately, a loss is created in the rental activity, then that activity will be deemed passive. In this manner, Congress has created an exception to the exception. To counter-balance this re-re-characterization risk, many will be tempted to increase the rental amount to above-market rates in order to absorb the excess depreciation and zero-out the income statement, if necessary. As a result of this obvious moral hazard, the IRS will scrutinize rental agreements to ensure that they fairly reflect an arm’s length rate. Accordingly, clients must be prepared to justify—and properly document—all of these requisite components carefully…
Plot Twist #2: In a self-rental scenario, a taxpayer who rents real estate to a corporation receives income that is exempt from self-employment (SE) income tax (IRC § 1402(a)(1)). This is a significant tax benefit given that SE tax can be as high as 15.3%. The exemption also applies to property (other than real estate) that is leased along with real estate. However, there is no exemption from SE income if personal property alone (i.e., without real estate) is leased to a corporation. More specifically, IRC Section 1402(a)(1) only excludes “rentals from real estate and from personal property leased with the real estate” from “net earnings from self-employment.” Therefore, unless property is rented in conjunction with real estate, the rental income generated is expressly omitted from the SE exemption as expressed in the statute.
Thus, when an individual leases property to a “controlled corporation”, whether an S corporation or a C corporation, and that property is not leased in conjunction with real estate, any net rental income risks exposure to SE tax. Of course, this assumes that the leasing activity is conducted with regularity and continuity, so as to rise to the level of a trade or business. Conversely, if the leasing activity does not rise to a level such that it would be considered “active” (without consideration of the self-rental rule), the SE tax should not be an issue. Unfortunately, there is no bright-line rule to determine when activity moves from passive to active (although there’s LOTS of case law!). That determination is based purely on an examination of the relevant “facts and circumstances” appurtenant to the taxpayer’s conduct.
Admittedly, the above Plot Twists might not be as scintillating as “the phone call is coming from inside the house,” “it was all a dream,” or others that make the hair on the back of your neck stand up. However, in the context of an extremely common, real-life business scenario like self-rental, arming taxpayers with the knowledge to make their tax story lines boring and predictable is always worth the price of admission.
Pass the popcorn!
If you have any questions regarding this article or would like to submit a question for a future Q&A, please email TLS Support: firstname.lastname@example.org.
[i] When you sell your rental property, you may be able to deduct your suspended passive losses from the profit you earn. It is important to note that, in order to take this deduction, you must sell “substantially all” of your rental activity. Moreover, the sale must be a taxable event—that is you must recognize income or loss for tax purposes.