We are all familiar with common business structure in which the operating business is owned by the individual(s) through one entity, the real estate is owned by the same individual(s) through a separate entity and the operating business pays rent to the real estate entity. This is a great method of protecting the value of the real estate from the operating risks of the business. It does however create a self-rental situation under the Internal Revenue Code.
Under the self-rental rules, if a taxpayer materially participates in the operating business and the taxpayer’s self-rental activity produces net income, the regulations treat that income as non-passive income. However, if the rental activity produces a loss, the loss is treated as from a passive activity. This is the worst of both worlds! If the loss is passive, it cannot be used to offset the income from the business that uses the property. If the income is active, the income cannot be offset with losses from other investment real estate.
An effective strategy to circumvent the limitations of the self-rental rules is to elect to group their separately owned rental building with their separately owned business and treat the two of them as one activity for purposes of the passive loss rules. In order to be eligible to elect, the rental must be owned by an individual, an S corporation, or an LLC (not in a C corp), the owners must have the same proportional ownership, and the activities constitute an appropriate economic unit (i.e., common control, common ownership, interdependency between activities). Easily met in the commonly owned company scenario.
By electing to group the activities, taxpayers can use the losses from the rental activity to offset active income from the business.
Bottom Line: Electing to group rental activities can be a valuable strategy to avoid the limitations imposed by the self-rental rules.
“Sometimes the grass is greener because it’s fake….” – Lindsey Lee and Co.