If you own property and a business, there is an obvious temptation to lease the property to the business. Such an arrangement can make sense from many perspectives.
You are no doubt familiar with the property and its advantages to your company. The deal could be carried out quickly, and the money would stay between you and your company. If you participate in other loss-producing passive activities, you may hope to offset the net rental income with those losses.
There is just one big problem: you would risk triggering the “self-rental rule” and not achieving your desired tax outcome.
“Self-rental rule” in a nutshell
Internal Revenue Code (IRC) Section 469 prohibits taxpayers from deducting passive activity losses (PALs).
It applies to “flow-through” income and losses from partnerships, limited liability companies (if they have elected to be treated as a partnership for tax purposes), S corporations, and trusts.
The rules define “passive activity” as any trade or business in which the taxpayer does not materially participate. Rental real estate activities are generally considered passive activities, regardless of whether the taxpayer materially participates. (There is an exception if the taxpayer qualifies as a real estate professional.)
A PAL is the amount by which the taxpayer’s aggregate losses from all passive activities for the year exceed the aggregate income from all those activities. A PAL can be used only to offset passive income, though there are a few exceptions.
The self-rental rule in IRC Section 469 applies when renting property to a business in which you or your spouse materially participates. Under the rule, any net rental losses are still considered passive, but the net rental income is deemed nonpassive. That means net rental income cannot be offset by other passive losses, yet net rental losses can offset only other passive income. This could have negative tax consequences if you hope to offset your self-rental net income with passive losses from other activities.
The power of grouping
You may be able to avoid the negative tax consequences of IRC Section 469’s self-rental rule by “grouping.” The regulations allow you to group your separately owned rental building with your business to treat them as one activity for purposes of the passive loss rules if they constitute an “appropriate economic unit.”
The regulations determine this based on factors such as common ownership and control, types of activities, and location. As long as you materially participate in the business – and the business is not a C corporation – the rental activity will not be treated as passive for the purposes of income or losses.
To take advantage of this option, you must own both the rental property and the business. You could also use grouping if the renting activity is “insubstantial” (a term undefined by the regulations) in relation to the business activity.
Find the best arrangement
Renting property to a business in which you materially participate can seem like a great idea; but doing so can turn out to be a lose-lose proposition when it comes to taxes, particularly for S corporation owners who may not understand the rules. Please contact our firm to help devise the most beneficial arrangement for you.
