If you own property and a business, there’s an obvious temptation to lease that property to the business. But be careful — you risk triggering the self-rental rule and catching the eye of the IRS. One creative couple tried to get around this by using an S corporation to lease their property to their business, but their effort fell flat.
Self-rental Rule in a Nutshell
The Internal Revenue Code (IRC) generally prohibits taxpayers from deducting passive activity losses (PALs). It defines “passive activity” as any trade or business in which the taxpayer does not materially participate. Rental real estate activities generally are considered passive activities regardless of whether the taxpayer materially participates.
A PAL is the amount by which the taxpayer’s aggregate losses from all passive activities for the year exceed the aggregate income from all of those activities. A PAL can usually only be used to offset passive income (although the IRC does provide a few exceptions).
The self-rental rule in IRC Section 469 applies when you rent property to a business in which you or your spouse materially participates. Under the rule, any rental losses are still considered passive, but the rental income is deemed nonpassive.
That means your rental profits can’t be offset by passive losses, and the rental losses generally can offset only passive income. You essentially forfeit the tax benefits from current rental losses unless you have passive income.
What Can Go Wrong
A couple in Texas owned two businesses: BEK Real Estate Holdings, an S corporation, and BEK Medical, Inc., a C corporation where the husband worked full-time. The S corporation leased commercial real estate to the C corporation. Neither the husband nor the wife materially participated in BEK Real Estate or otherwise engaged in a real property business.
In 2009 and 2010, BEK Real Estate had net rental income of $53,285 and $48,657, respectively, solely from the rental of property to BEK Medical. The couple reported those amounts as passive income on their 2009 and 2010 tax returns. They offset the income with passive losses from other businesses. The IRS, however, reclassified the rental income as nonpassive and disallowed the passive losses they claimed in excess of their adjusted passive income for 2009 and 2010.
As a result, the couple couldn’t deduct their rental income from any of their passive losses, so the passive losses that exceeded their passive income were suspended. Moreover, they owed more than $26,000 in taxes on the rental income for the two tax years.
They appealed to the U.S. Tax Court. When the court ruled in favor of the IRS, the couple appealed to the Fifth Circuit Court of Appeals.
An Unusual Challenge
The couple argued that the self-rental rule didn’t apply because Sec. 469 doesn’t define “taxpayer” to include S corporations. And, they claimed, even if it did, BEK Real Estate didn’t materially participate in BEK Medical.
The Fifth Circuit Court acknowledged that Sec. 469 doesn’t refer to S corporations at all: “The statute specifically applies to ‘taxpayers’ who are individuals, estates, trusts, closely held C corporations, and personal service corporations.” But the appellate court agreed with the Tax Court that the provision didn’t need to specifically refer to S corporations because S corporations are merely pass-through entities — the individual shareholders in an S corporation are the ultimate taxpayers, not the entity.
Therefore, the Fifth Circuit found that an S corporation isn’t really a taxpayer. And, because S corporations don’t pay taxes directly, Sec. 469 had no need to include them in its list of potential “taxpayers.”
The material participation argument regarding the S corporation’s level of participation also failed. The couple were the taxpayers, so the proper focus wasn’t on the S corporation but on the couple. The husband, who worked full-time for the C corporation, indisputably materially participated in its business.
A Potential Reprieve
One strategic opportunity to consider regarding the self-rental rule is “grouping.” The IRC allows you to group your separately owned rental building with your business to treat them as one activity for purposes of the passive loss rules if they constitute an “appropriate economic unit.” The regulation determines this based on factors such as common ownership and control, types of activities and location. As long as you materially participate in the business — and the business isn’t a C corporation — the rental activity won’t be treated as passive.
To take advantage of this option, you must own both the rental property and the business. You could also use grouping if the rental activity is “insubstantial” (a term undefined by the regulations) in relation to the business activity.
There are many tax-advantageous strategies for property owners to consider; however, renting property to a business in which you materially participate is generally a lose-lose proposition when it comes to your taxes.
Contact Angel Rice at firstname.lastname@example.org to discuss your tax situation further.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.