The passive versus non-passive income portion of the tax code is one of the most misunderstood portions of the code. To add to the dilemma, a simple misreading has the potential to result in financial losses amounting to hundreds of thousands of dollars for the typical investor.
The treatment of self-rentals under the passive activity loss rules is a nuanced aspect of tax law that can have significant implications for property owners. We get so many questions about this every month that I felt it would be a good idea to write a blog about it.
Section 469 of the Internal Revenue Code is a crucial regulation impacting individuals, estates, trusts, and certain corporations by limiting the ability to offset passive activity losses against other income. A passive activity, as defined by the IRS, generally includes trade or business activities in which the taxpayer does not materially participate, such as rental properties or limited partnerships.
Section 469 provides that a passive activity loss will not be allowed except to the extent of passive income. This means that losses incurred from passive activities can only be deducted against income generated from other passive activities. Most investors know this fundamental rule, but there’s so much more to it, especially when you have a self-rental.
Section 469(c)(2) also states that passive activity includes ANY rental activity. A Real Estate professional is an exception to §469(c)(2), but that is a whole different topic. We want to focus on self-rentals, which is also an exception.
The self-rental rules apply when a taxpayer owns a business as well as the real estate where the business operates, like a dentist owning the building his practice is in. This situation usually involves two separate entities for liability purposes—a real estate entity (think landlord) and an operating entity (think tenant).
Assuming the taxpayer materially participates in the operating company’s activities (VERY generally speaking, you materially participate if you’re involved in the operation of the activity on a regular, continuous, and substantial basis), any rental income produced by the entity is deemed to be active rather than passive. This makes sense because the operating company’s income is active. If money is taken out of the operating company (tenant) and sent to the landlord, it should also be active.
But, assume that the taxpayer has a loss on the rental property. This means that the operating business does not pay enough rent to cover the expenses and depreciation of the rental property. Although rental income is reclassified to be active, any losses produced by the rental activity are still considered to be passive. That loss is subject to the passive loss rules, so the loss will be suspended and carried forward to future tax years.
However, any income produced by the landlord entity to which the self-rental rules apply cannot be netted against passive losses from other rental entities to apply those losses. It often results in passive losses being “trapped” by the Section 469 passive activity loss rules.
This is the SELF RENTAL TRAP.
However, the self-rental reclassification comes with a small benefit in certain situations. The Patient Protection and Affordable Care Act implemented the 3.8% net investment income tax (NIIT). This is also called the Obama Care Tax. Typically, the NIIT would apply to any passive income generated by rental real estate. However, the self-rental rules reclassify this rental income as active income. §1.1411-4(g)(6) specifies that rental income from a self-rental activity is not subject to NIIT, which means that taxpayers have lower marginal tax rates on self-rental income than if it were passive rental income.
In addition, the qualified business income (QBI) deduction under §199A would not typically apply to passive rental real estate activities except in very limited circumstances. However, §1.199A-1(b)(14) describes that self-rental activities are eligible for the QBI deduction if they meet the aggregation requirements (the same person or group of persons must directly or indirectly own 50% or more interest in each business for the majority of the taxable year). This provision gives an advantage to self-rental income compared with typical rental real estate income.