In our previous blog, we delved into the self-rental trap that ensnares many business owners. To recap, any rent paid to a landlord entity in a self-rental scenario is considered active income. However, if the landlord entity experiences a net operating loss, that loss is classified as passive.
Let’s explore this concept further. Imagine you own two rental properties: a single-family rental and a warehouse. You rent the warehouse to your business and materially participate as the owner. Meanwhile, due to AirBnB restrictions, the single-family rental remains unoccupied for the year, resulting in a $25,000 loss. Conversely, the warehouse generates a net income of $25,000.
Intuitively, you might think you can offset the income from the warehouse with the loss from the single-family rental. Unfortunately, this is where the self-rental trap springs. Since you rented the warehouse to your own business, the self-rental rule treats the income as active. Consequently, you cannot offset it with the passive loss from the single-family rental.
Let’s complicate the scenario further. Suppose you also incur a net loss on the warehouse (rental entity). This loss is added to the passive loss from the single-family rental, rendering it non-deductible unless you have other sources of passive income.
Now, consider that you have decided to sell a business you’ve owned for ten years but keep the warehouse building to rent to the new business owners. This is a common strategy. You plan to use the rental income to offset the passive loss from the single-family rental. Logical, right? Wrong.
Why?
Under the material participation rules, if you have materially participated in a business for five out of the past ten years, you are still considered materially participating even after selling the business. Consequently, under the self-rental rule, the rental income remains active. This means you cannot offset it with the passive losses from the single-family rental for at least five years.
Confused? You’re not alone. The U.S. Tax Code is notoriously complex and often seems nonsensical. For personalized advice, feel free to call me at 502-216-594.