Don’t get caught in a trap of unintended consequences.
The only thing worse than incurring a loss on investment property is incurring a
loss that cannot be deducted for tax purposes. Self-rental property may cause this tax
result for some property owners if rental arrangements are not strategically prepared.
The following overview of the self-rental rule, including an explanation of passive
activities in the context of rental real estate, may shed light for property owners who
want to avoid such tax consequences.
Passive Activities Concept
The Internal Revenue Service considers most business activities to be nonpassive if
a taxpayer materially participates in the business. One exception to this rule is
rental real estate.
Partly because of their past use in tax shelters, rental real estate activities are
generally considered passive regardless of participation level. (There are exceptions
that go beyond the scope of this article.) The distinction between passive and
nonpassive activities is important because under the passive activity loss rules, a
passive loss usually can only be used to offset passive income. Generally, any passive
loss that exceeds passive income is suspended and carried forward to be deducted in a
future year. However, there is an exception of up to $25,000 for taxpayers who actively
participate in a rental real estate activity. Nonpassive loss, on the other hand, can
offset both passive and nonpassive income.
Taxpayers can generally offset rental income from one property by rental loss from
another property, as passive loss is deductible to the extent of passive income.
However, an exception to this simple rule occurs when property is rented to one's self
or a business in which one materially participates. In such a case, the rental real
estate activity's treatment as passive or nonpassive varies depending on whether it
produces income or loss.
For example, assume Juan has three activities for tax purposes: He is the sole owner
of a bookstore, in which he materially participates, and he owns two rental
properties—a warehouse and an apartment building—that are passive by
nature. The activities generate $150,000 income and $100,000 loss, with a net gain of
$50,000. (See Example 1.) The rental loss can offset rental income, with the excess
loss then suspended. The result for Juan is $100,000 of taxable income and $50,000 of
But suppose Juan rents the warehouse to his bookstore instead of an unrelated third
party. This is when the self-rental rules come into play to recharacterize the rental
In the case of a self-rental, income is treated as nonpassive and loss is treated as
passive. Thus, the warehouse income is nonpassive and the apartment loss cannot be
deducted against it. Because of the self-rental trap, Juan's tax result is $150,000 of
income and $100,000 of suspended loss, as shown in Example 2.
Because he is renting to himself, Juan controls the rent that the bookstore pays. By
adjusting this amount he can theoretically create a loss for the bookstore. If he
increases the bookstore's rent for the warehouse by $125,000, he will get the results
in Example 3, which is $150,000 in taxable income and $100,000 in suspended losses.
Again, because it is a self-rental, the warehouse income is treated as nonpassive.
The result would be the same even if Juan's spouse was running the bookstore
business. In determining material participation, participation by Juan's spouse is
considered participation by him as well. The self-rental rule's primary purpose is to
prevent taxpayers from manipulating rent for companies they (or their spouses) own and
operate to create passive income to use against other passive losses.
Avoiding the Trap
Taxpayers can avoid or reduce the detrimental tax effect of the self-rental rule.
One way is to reduce their participation level in the operating activity so it fails
the material participation tests. Then both the operating activity and the rental
activity will be considered passive and the self-rental rule will not apply. However,
it is usually not feasible for owners to reduce their participation, especially when
the operating activity is their primary business. The interplay of the operating
activity and its income or loss with any other activities of the taxpayer should be
analyzed in aggregate prior to considering a reduction in participation.
A more reasonable method of combating the self-rental rule is to minimize net income
for the rental activity. A net loss will still be subject to the normal PAL rules, so
minimizing loss may be important as well. However, fair-market rent must be charged, as
an artificially high or low rent used to manipulate income will not withstand IRS
Another option is to rent from a third party. To avoid the poor tax results in
Example 2, Juan's bookstore could rent a warehouse from an unrelated party and he could
rent his warehouse to another unrelated company for an offsetting amount. This method
relies heavily on market conditions that allow Juan to find both a tenant for his
property and his own lease space.
It's not always easy or practical to avoid the reclassification of income under the
self-rental rule. Property owners or investors who rent to themselves or their entities
should be aware of the potential tax consequences that can make a bad situation even
Daniel Rowe, CPA, is a tax manager at the accounting firm Deemer Dana & Froehle
LLP in Savannah, Ga. Contact him at email@example.com.