IRS tax rules for self-rental properties

When a taxpayer owns and materially participates* in an operating business AND also owns the accompanying real estate rented to that operating company, that is defined as a “Self-Rental” per IRC, Sec. §469.  There are complex regulations around reporting income and losses of self-rental property and taxpayers should be well-versed in the rules.

Tax consequences of income and losses for self-rental property

In many instances, an operating business (tenant) and a rental real estate entity (landlord), are separate entities but both owned by the same taxpayer.  In this case, the rental income is deemed to be “Self-Rental”.

  1. Net rental income from a self-rental property is treated as non-passive** income.
  2. Net rental losses from self-rental property are treated as passive** losses.

The result is that self-rental income, for the landlord, is essentially reported on a “stand alone” basis.  The income derived from this self-rental cannot be used to offset any other rental losses, even if the losses are from other, commonly owned self-rental properties.  This is true even if there are self-rental losses originating from other businesses that also have material participation by the same taxpayer.

Self-rental losses, on the other hand, are passive losses.  Passive activity losses can only be used to offset other passive income.  The current year self-rental losses, absent any other passive income for the year, will be suspended (“trapped”).  If there is rental income in future years from this self-rental activity, the prior year(s) trapped losses can be used against this future income.  Thus; prior years’ suspended passive losses from this activity can be carried forward and used to offset the current and future year rental income.

Sale of Operating-Lessee Company with Real Estate Retained

If there is a sale of the operating company/lessee but the taxpayer/landlord continues to own the property and leases it to a new (unrelated) purchaser, there are still more restrictions:

  • The future rental income generated from the rental of this property, per the self-rental rules, would still be considered non-passive (active), if the taxpayer had materially participated in this business activity for five out of the past 10 years.  To say it in simple terms; the taxpayer/landlord could still be considered as actively participating in a business that has been sold, for the subsequent five years after the sale if the taxpayer had run the business for five years prior to the sale.

Self-Rentals and Net Investment Income Tax

Net Investment Income Tax (NIIT) is a 3.8% tax on passive income.  A trade or business is not a passive activity.  Self-rental income, if treated as a non-passive activity per the rules previously noted, is not subject to NIIT.

Self-rental is a common tax situation that has very complicated rules.  The best way to manage this tax structure is to be aware of these rules, and plan accordingly.  Landlords, for self-rental tax planning, should make sure that the rent they are charging is reasonable and is competitive with current market rates.  Self-rental income is usually more tax-efficient than self-rental losses.

For more information on properly reporting self-rental income, contact a ShindelRock tax professional.

*Material participation, in any operating business, requires that the taxpayer participate on a regular, continuous, and substantial basis.

**Passive activity is any trade or business in which the taxpayer does not materially participate. IRC 469(c)(2) states that passive activity includes almost any rental activity.