Revisiting Self-Rental Rules

As tax professionals, we often find taxpayers buying or building commercial real estate to house their primary business, rather than paying rents to a third party. This is a sound financial strategy, as it allows the business owner to participate in the appreciation of the real estate, have peace of mind concerning the location of his business and control the terms of the lease. 

Per IRC §469(c)(2), rental real estate is an inherently passive activity. However, if a taxpayer rents property to a trade or business in which he materially participates, net rental income is re-characterized as non-passive (§469-2(f)(6)). Net rental losses from the same activity generally remain passive. This being the case, the following potential risks exist when participating in a self-rental situation:

·      Net income from self-rental activities cannot be arranged so as to be offset by net losses from other passive activities

·      The netting of profits and losses from self-rental activities is not permitted

·      Self-rental net income is not portfolio income, i.e., no deduction of investment interest expense is allowed and is not recognized as a source of investment income

Care must be taken by the tax preparer to understand the self-rental rules and properly categorize self-rental net income as non-passive and not include it as passive income on Form 8582.