Many taxpayers who own a business also own the real estate used by that company. So how do you best protect yourself when you own both the operations and real estate of a business? The most common solution is to hold the real estate in an entity separate from the operations of the business and lease back that property to the business.
This arrangement between a business and a rental property that are owned by the same person is called a “self-rental.” For the self-rental rules to apply, the person has to materially participate in the business. This arrangement is a common business practice, primarily used to legitimately limit the owner’s liability exposure.
If you decide to separate your real estate from the operating portion of your business, you must first determine what form of entity to use for holding the self-rental real estate. The most common entity used is a limited liability company (LLC).
The benefits of an LLC are (1) better liability protection for the business owners, (2) flow-through tax treatment to the owners, and (3) tax-friendly transfers of properties in and out of the entity. If your business is operating as an LLC, you may have the added advantage of removing the net rental income from the burden of self-employment tax.
The Self-Rental “Trap”
The advantages of self-rental are many but there are also issues related to self-rental that must be understood. Like other expenses, rent must be “ordinary and necessary” for the operating entity to deduct the expense. The IRS requires that the rent be at fair market value, so self-rental taxpayers should document their proper rental rate by comparison to existing rents in the local area.
In general, rental income is considered to be “passive” income rather than “active” (earned) income. Passive income is income received on a regular basis, with little effort on the part of the recipient to maintain it. The IRS defines passive income as only coming from two sources: rental activity or “trade or business activities in which you do not materially participate.”
The IRS, however, considers self-rental income as nonpassive. What would ordinarily be considered income from a passive activity is treated as non-passive income because the owner materially participates in the operating-lessee entity. A taxpayer with net income from a self-rental cannot offset this income with losses generated from other rental property. This rule prevents a taxpayer with passive activity losses from other rental property artificially creating passive income within the self-rental to absorb those losses.
On the flip side, a net loss from the self-rental is considered passive. The net loss from the self-rental activity is only deductible to the extent of passive income generated. A self-rental activity with a loss would not be currently deductible. The passive loss would be carried forward and could be used in future years, when other passive income is generated. Please note, in this situation, if the self-rental activity generated income in future years, that income can be offset only by the passive losses coming forward from the self-rental activity.
Making Self-Rental Work for You
Separation of the operating and real estate components of your business is sound business and tax sense. Current proposed regulations for the new 3.8 percent federal tax on net investment income in 2013 for higher income taxpayers include passive activity income in that category. Although income from self-rental is not considered passive activity income, the proposed regulations interpret the law as imposing an additional requirement for exemption from the net investment income tax: that the activity be a trade or business.
Rental without significant services has not been considered a trade or business in the past. Therefore, the ability to reduce self-employment tax through self-rental will be limited to owners who are not subject to the net investment income tax. Owners of property rented to an S corporation may find that their taxes are increased by the 3.8 percent net investment income tax on the self-rental.
To set up a self-rental, consult your attorney and tax advisor to assist in selecting the structure that best meets your needs and to ensure you do not undermine your business and tax goals. The assistance of a knowledgeable tax advisor in structuring a self-rental can translate into peace of mind and dollars saved.
Content contributed by Potter & Company, a local certified public accounting firm offering core services of tax, audit, business consulting and financial analysis. Content written by Kenni Doyle, CPA. For more information, contact him or Sam Leder, CPA, Partner, at 704-786-8189 or visit www.GoToPotter.com.