The Self-Rental Tax Trap

The current economic environment has caused an upheaval in the real estate market, especially in the commercial property arena. Many business owners are taking advantage of this by renegotiating their leases or purchasing buildings for their operations.

A common practice among small, closely held corporations is that of self-rental. Under this arrangement, a business owner purchases a building either personally or through another entity and leases it back to their corporation. The Journal of Financial Service Professionals published an article by Thomas M. Brinker, Jr., CPA/PFS, ChFC, AEP in their September 2010 edition titled “The Self-Rental Dilemma: Is Net Rental Income or Loss Passive for Planning?” You can get more information on the journal and subscribe online at http://www.financialpro.org/pubs/journal_info.cfm.

The article points out how Section 469 of the tax code, which provides for self-rental rules, is highly complex and confusing. The possibility for a tax trap is high when considering self-rental given the complexity of the rules. It is important to consult with a professional when dealing with this type of scenario.

Self-rental income is passive, to the extent that it represents a separate venture into real estate. As a general rule, passive losses from one activity may offset income from other passive activities, subject to IRS limitations. Many business owners are under the impression that if they have rental income from property they are renting back to their corporation, that income can be offset by losses from other passive activities. This view is often incorrect.

Passive losses can only be used to offset passive income. If an owner “materially participates” (i.e., is a shareholder or works in the business) in the corporation that is renting the real estate, income from the real estate activity is considered non-passive. Any losses from other passive activities may be carried forward to offset future passive income, but aggregating losses to offset income from self-rental in which an owner materially participates is disallowed.

To confuse things a little more, the Section 469 does allow passive income to be offset by self rental losses, up to IRS limits, and excluding any excess loss (excess loss may be carried forward in future years to offset passive income). Tax planning in these scenarios is key because any income or losses from passive activities or self-rental can have a significant impact on your tax liability.

If you currently use self-rental as part of your tax strategy, consult a professional to ensure that your strategy and tax reporting are in compliance with Section 469.