Avoid the Self-Rental Trap

Let’s say you own the building. (first, yay good for you)

Now, let’s say that you rent this building to your business. With no tax planning, you have a self-rental, and that

Makes rental income from this building non-passive, meaning that it cannot offset any passive losses1 (very bad)
Makes rental losses from this building passive losses, meaning that you likely cannot deduct the losses this year (also very bad).

There you have it: no tax planning = no deductions on losses

Moral of the story? Tax planning

Under a special grouping rule, you can qualify to group your separately owned rental building with your separately owned business and treat the two of them as one activity for purposes of the passive loss rules.

Ownership

Rental: Your ownership of the rental might be as an individual, an S corporation, or an LLC. For this strategy, you can use any of these forms for your ownership.

Business: You can own the business as a proprietorship, an S corporation, or an LLC—all these forms work for this strategy.

Note that the C corporation does not work. More on this later.

Like magic? How about turning 2 into 1

What makes two into one possible? Your ownership!

Accordingly, the regulations state that if each owner of the business has the same proportionate ownership interest as each owner of the rental, then the taxpayers may group the business and rental activities as one activity.

OK, Now in English, owners of business must have the same % ownership in the rental property. Then each owner can combine the business and rental into one see 2 into 1.

Therefore, you have no problem here because you have both 100% control and 100% ownership of both the business and the rental.

And if you are married, you can include your spouse in the mix.

Here’s how it works:

Now, say you have an office building that you rent to 3 other businesses. The breakdown would be like so, your office a self-rental (25%) would be active property rental giving you specific tax advantages. The other 3 businesses would amount to 75% passive loss rule. This brings into effect other forms of loss and tax deductions.

Beware: C Corporation Fails

The IRS says it with the greatest clarity: “No grouping of a rental with a C corporation ever. Rentals can be grouped with a C corporation only to determine material or significant participation.”

This goes to show there is an up side and a down side to every type of business entity.

Election (not that kind of election)

If you qualify to group your self-rental with your business, you need to make a formal election to let the IRS know what you are up to.

The election statement must include names, addresses, and employer identification numbers (if applicable) for the trade or business activities or rental activities that are being grouped as a single activity.

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