IRS Self-Rental Rules for Business Owners
Renting personal property to your business has unique tax consequences. Learn how IRS rules on this arrangement affect the character of your income and losses.
Many business owners personally own the real estate their company uses and lease it to the business. While this arrangement can be useful for asset protection, it is governed by specific IRS regulations known as the “self-rental rules.” These rules create a unique tax situation that differs from standard rental activities, making them important for business owners to understand for tax compliance and planning.
Understanding the Self-Rental Rule
The self-rental rule is part of the broader passive activity loss (PAL) rules under Internal Revenue Code Section 469. Tax code normally prohibits taxpayers from deducting losses from passive activities, like most rental real estate, against non-passive income like wages. This prevents using investment losses to shelter primary income from tax. The self-rental rule, found in Treasury Regulation §1.469-2, is an exception to this framework that recharacterizes rental income to prevent it from being classified as passive, closing a loophole for offsetting other passive losses.
Tax Treatment of Self-Rental Income and Losses
The defining feature of the self-rental rule is its asymmetrical treatment of net income and net losses. This dual treatment depends on whether the rental activity results in a profit or a loss for the tax year. The rule’s consequences are applied after calculating all rental income and deducting related expenses like mortgage interest, property taxes, and depreciation.
Net Rental Income
If the self-rental arrangement produces net income, the rule recharacterizes it from passive to non-passive. This means the income cannot offset passive losses from other sources, like a different rental property. For example, if an owner has $20,000 in net self-rental income and a $15,000 passive loss from an unrelated property, the income cannot absorb that loss. The owner reports the $20,000 as non-passive income, and the $15,000 loss is suspended. A benefit is that this non-passive income is not subject to the 3.8% Net Investment Income Tax (NIIT).
Net Rental Loss
Conversely, if the rental activity generates a net loss, the self-rental rule does not apply, and the loss keeps its passive character. This loss is subject to the standard passive activity loss limitations and can only be used to offset income from other passive activities. If the taxpayer has no other passive income, the self-rental loss is suspended and carried forward to future years until it can be used or the property is sold. This prevents taxpayers from creating deductible non-passive losses to shelter active business income.
Defining Material Participation
The self-rental rule is triggered by the taxpayer’s “material participation” in the business leasing the property. Material participation is a standard defined by the IRS to determine if involvement is regular, continuous, and substantial. An individual only needs to meet one of seven tests found in Temporary Regulation §1.469-5 to be considered a material participant.
Common tests for material participation include:
- Participating in the business for more than 500 hours during the tax year.
- Having participation that constitutes substantially all of the participation in the activity for the year.
- Participating for more than 100 hours, if that is not less than the participation of any other individual.
- Having materially participated in the business for any five of the ten preceding tax years.
Other tests look at participation over longer periods, such as for personal service activities, or combine participation across several “significant participation activities.” A final test evaluates the overall facts and circumstances of the taxpayer’s involvement.
The Grouping Election
Business owners can use a grouping election under Treasury Regulation §1.469-4 to mitigate the adverse effects of the self-rental rule. This formal election allows a taxpayer to treat their rental activity and their business as a single, combined activity for passive loss purposes. By grouping the two, the distinction between the rental and the business is eliminated.
If the taxpayer materially participates in the operating business, the entire grouped activity becomes non-passive. This allows any net losses from the rental portion, often from depreciation, to directly offset the business’s operating income. To qualify, the activities must constitute an “appropriate economic unit,” considering factors like common ownership, common control, and interdependencies, which are often met in a self-rental scenario.
This election is a formal process that must be made by attaching a statement to the tax return for the first year the grouping is effective. The statement must identify the activities being grouped and declare that they constitute an appropriate economic unit. Once made, the grouping election is binding for future tax years unless a material change in circumstances occurs, such as a sale of the business or property.