A portion of a taxpayer’s gross income from an item of property used in a rental activity is recharacterized from passive to non-passive income if:
- The property is rented for use in a trade or business activity in which the taxpayer materially participates; and
- The property does not qualify as property rented incident to development activity.
This rule is popularly known as the “self-rental rule. This rule converts passive income into non-passive income. A passive activity is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. A passive activity generally includes all rental activity.
Let’s assume that a taxpayer has ownership of an operating company and also owns a separate entity that owns the real estate that is leased to the operating company. The taxpayer materially participates in the operating company. In this situation, the rental income received from the operating company which would normally be treated as passive income becomes recharacterized as non-passive.
The rule was implemented to prevent a taxpayer with passive activity losses from various other entities from artificially creating passive activity income to absorb such losses.
While planning a self-rental transaction, a taxpayer must pay attention to several risks:
- The self-rental rule only recharacterizes the rental income as non-passive. The rental loss on the rental property is considered as passive. Therefore, if there is no passive income in the current year, the loss will not be deductible but suspended and carried forward to future tax years.
- The self-rental rule recharacterizes the rental income from an item of property, rather than from an activity. For instance, if taxpayers owned Property A, which they rented at a profit to ABC Corporation, and Property B, which they rented at a loss to XYZ Corporation, and where taxpayers materially participated in the activities of both corporations, the rental income from Property A had to be recharacterized as non-passive under the rule applied to the income from the rental of Property A—an item of property—and not to the net income from Property A/Property B rental activity. As a result, the income from the rental of Property A (recharacterized as non-passive) couldn’t be used to absorb the loss from Property B (which had to be treated as passive under the rule generally treating rental activities as passive activities).
- The self-rental rule applies where property is rented to a C corporation that’s subject to the passive activity loss rules in which the taxpayer materially participates.
- Activities of the taxpayer’s spouse are also attributed to the taxpayer. Thus, for example, rental income received by an individual taxpayer pursuant to a lease of office space to her spouse’s corporation is recharacterized as non-passive income.
Self-rental rule transactions should be carefully planned to treat the passive losses in favor of the taxpayer. Consulting professionals in this matter can save and avoid significant tax implications.
