Avoiding the Self-Rental “Trap”
Finding your way through the passive activity rules can be an overwhelming task. Passive activity loss limitations can often lead to unintended outcomes. This is particularly evident when it comes to the self-rental rules.
For various tax and legal reasons, a taxpayer may decide to hold an operating company and the real estate in which it operates in separate entity structures. Renting the building to “yourself” is allowable under the tax code and is encouraged. Sound tax planning will help make sure that the losses from your rental activity do not get “trapped” because of the passive activity loss rules.
Passive Activity Losses
Passive activity losses are only allowed to the extent there is passive income. Any passive losses that cannot be taken in the current year are carried forward until they can be taken against any future passive income. Section 469(c) of the Internal Revenue Code defines passive activities as “any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate [; including] any rental activity.”
In self-rentals, passive activity losses are common because of tax deductions related to depreciation of the building, real estate taxes, and mortgage interest.
Illustration. Steve incurs non-passive income of $400,000 through his operating company in LLC A. Steve’s rental real estate (from which LLC A rents) is owned by LLC B and generates a passive loss of ($50,000). Because passive losses can only be taken against passive income, Steve’s passive loss of ($50,000) will be carried forward to future years until he generates passive income. Steve would have $400,000 of taxable income in the current year.
One might ask, “can I just increase the rent to incur passive income in the future to use the passive losses?” The short answer is no. Highly inflated or deflated rental values will not pass IRS scrutiny. The IRS requires that you charge fair rental value.
Another question that frequently comes up is, “can I use passive income from the rental activity to offset losses from other passive activities?” In general, no. In self-rental transactions, income generated is considered non-passive. While a taxpayer can use the non-passive income generated by the rental real estate to offset passive losses generated by the same rental, the non-passive income cannot be used to offset losses from other passive activities.
Therein lies the “trap.” Passive losses are suspended and can only be used against passive income. Passive income from self-rentals is categorized as non-passive income and cannot be used to offset passive losses from other activities.
There are two possible solutions to this problem. First, the taxpayer can legally merge the two businesses into one. This would eliminate the two different types of income. However, for legal reasons (mentioned above), a taxpayer may need to keep these two activities separated.
This leads us to the second option. The taxpayer can make an election in the initial year that he starts the self-rental activity to aggregate the activities. Normally grouping rental and business activities is disallowed, but if both activities form an appropriate economic unit and meet other grouping stipulations outlined by the IRC then they can be grouped. This essentially has the same effect as merging the activities into one.
With proper tax planning, the self-rental “trap” can be avoided. We would love to talk to you about these ideas and other ideas that might be more specific to your individual circumstances. Give us a call at (949) 260-1430.
Written by Kevin Day, esq., LLM