The self-rental rules: Risks and opportunities

The COVID-19 pandemic ushered in erratic price behavior for commercial real estate, with many markets quickly reaching new highs and others experiencing declines. The Federal Reserve’s Commercial Real Estate Price Index climbed over 20% in a little over a year from the third quarter of 2020 to the fourth quarter of 2021.1 Shortly thereafter, commercial real estate prices moderated. The variation in pricing forecasts from this point is considerable.

The uncertainty surrounding commercial real estate brings with it a renewed focus on potential tax planning risks and opportunities, including those involving the self-rental rules. Issues such as determining fair rental value under volatile market conditions can add increased complexity to an already complex area of the tax law. In any rental real estate activity, the passive activity loss rules can often be intimidating for taxpayers. Specifically, Sec. 469(c) provides that rental real estate income, with two exceptions,2 is typically considered a passive activity, meaning that any losses produced by the activity must be netted with income from other passive activities.

Often a blind spot for practitioners, the self-rental rules create asymmetric treatment of income and losses under the passive activity loss rules, which can result in unanticipated tax consequences unless carefully considered in advance. Because self-rentals also yield scenarios ripe for manipulating income between active and passive sources, Regs. Sec. 1.469-2(f)(6) provides specific guidance on the treatment of income from self-rental activities.3

What is a self-rental?

The self-rental rules may apply when a taxpayer owns, in a separate entity, real estate associated with an operating company. An example is where a physician operates a medical practice through a wholly owned S corporation but owns the building through a different S corporation that receives rent from the first S corporation. Taxpayers often choose to structure real estate in a separate entity for non-tax-liability reasons. Assuming the taxpayer materially participates in the operating company’s activities, any rental income produced by the entity is deemed to be active rather than passive.

Pursuant to Regs. Sec. 1.469-2(f)(6), such reclassification applies to any operating company in which the taxpayer materially participates under Temp. Regs. Sec. 1.469-5T, except for development activities defined in Temp. Regs. Sec. 1.469-2T(f )(5). This treatment means that any income produced by a rental entity to which the self-rental rules apply cannot be netted against passive losses from other rental entities to utilize those losses. Ultimately, it often results in more passive losses being trapped by the Sec. 469 passive activity loss rules.

Importantly, many of the difficulties related to the self-rental rules stem from the fact that reclassification applies only to income. Implicitly, although rental income is reclassified to be active, any losses produced by the rental activity are still considered to be passive. As previously noted, this asymmetric treatment has adverse consequences for taxpayers in many situations because the rental income is not available to offset passive losses from other entities.

Uniquely, the active rental income in one year of a self-rental is available to offset prior passive losses from the same self-rental activity.4 The IRS has typically been successful in achieving a broad reach for the self-rental rules, including overcoming grouping rules,5 challenging sheltering rules,6 looking through entities,7 and even defending the regulation itself.8 The IRS has also successfully challenged claims that the self-rental rules do not apply to C corporations.9 Collectively, the self-rental rules have important implications for taxpayers who own a separate entity that rents property to an operating entity in which they materially participate.

Recent developments

However, the self-rental reclassification comes with somewhat of a silver lining in certain situations. The Patient Protection and Affordable Care Act,10 in an important development in the previous decade, implemented the 3.8% net investment income tax (NIIT). 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. Consistent with the reclassification, Regs. Sec. 1.1411-4(g)(6) provides that rental income from a self-rental activity is not subject to NIIT, which means that taxpayers enjoy lower marginal tax rates on self-rental income than if it were passive rental income.

In addition, the qualified business income (QBI) deduction under Sec. 199A11 would not typically apply to passive rental real estate activities except in limited circumstances. However, Regs. Sec. 1.199A-1(b)(14) explains that self-rental activities are eligible for the QBI deduction if they meet the aggregation requirements under Regs. Sec. 1.199A-4(b)(1)(i). Again, this provision gives an advantage to self-rental income compared with typical rental real estate income.

In the uncertain economic times following the COVID-19 pandemic, one of the most salient issues surrounding the self-rental rules is establishing a fair rental value for the property. The IRS reserves the right to reclassify rents in excess of fair rental value as dividend distributions (in the case of a C corporation).12 Additionally, the IRS can adjust rents under fair rental value for both the self-rental entity and the operating entity, resulting in a contribution to capital for the operating company and a deduction for the operating company for the fair rental value, which must be matched by fair rental value income recognized by the self-rental entity under Sec. 482. Accordingly, contemporaneous support for the rental amount appears crucial.

Tax planning risks

The major risks associated with the self-rental rules stem from the broad application of these regulations. Without advance planning, the self-rental rules can impose a significant and unanticipated burden on taxpayers. For example, a taxpayer expecting to use income from a self-rental activity to utilize passive losses from other sources would be unable to do so.

Additionally, the self-rental rules can have effects that linger well after the sale of the operating company. Because the material participation tests under Sec. 469 employ a 10-year testing period, a taxpayer is deemed to be a material participant in an activity if they were a material participant in that activity for five or more of the 10 preceding years.13 Applied to a self-rental situation, this rule means that even after the operating company is sold, the rental income is subject to the self-rental rules for up to an additional five years if the taxpayer retains the rental entity. The following examples illustrate some of the tax planning risks that can arise from the self-rental rules.

Example 1 (baseline risks): In 2023, J operates a grocery store through a wholly owned S corporation (OpCo). He owns the building and land associated with the grocery store in a separate S corporation (RentCo), which rents the building and land back to OpCo. J receives a $250,000 salary from OpCo and is allocated an additional $100,000 in ordinary business income. RentCo produces $50,000 of income allocable to J, and he has $25,000 of passive loss from other activities.

In this situation, J cannot utilize any of the passive loss because he has no passive income to offset it. He has $400,000 of active income ($250,000

$100,000 + $50,000), of which $150,000 ($100,000 + $50,000) is QBI income for purposes of the QBI deduction and not subject to NIIT because it is considered nonpassive income. The $250,000 is not included in the computation of QBI since it is not income that flows through the S corporation. In some circumstances, the business activities of the operating company can sour the QBI deduction for the self-rental activity. Under Regs. Sec. 1.199A-5(c)(2)(i), if a business provides property to a specified service trade or business (SSTB) and there is 50% or greater common ownership of the businesses, the portion of the business providing property to the SSTB is treated as a separate SSTB with respect to the related owners. As such, if the operating entity is an SSTB under Sec. 199A, provided there is 50% or more common ownership of the rental entity, the income derived from the portion of the rental entity providing property would not be QBI for purposes of the QBI deduction. However, if the 50% common ownership threshold is not met, the self-rental income of a rental entity is not considered to be SSTB income and may be QBI income for purposes of the QBI deduction, even if the business to which the rental entity provides property is an SSTB. This situation could occur if three or more taxpayers jointly own a rental entity but independently own separate operating companies.

Example 2 (self-rentals and SSTB operating entities): In 2023, K, a pediatrician who is a single taxpayer, operates his physician practice through a wholly owned S corporation (OpCo). He owns the building and land associated with the practice in a separate S corporation (RentCo), which rents the building and land back to OpCo. K receives a $250,000 salary from OpCo and is allocated an additional $100,000 in ordinary business income. RentCo produces $50,000 of income allocable to K, and he has $25,000 of passive loss from other activities.

In this situation, because K’s operating company is a physician’s practice, if his taxable income is above the SSTB phase-in range for the year, his income from the practice is not eligible for a QBI deduction. Further, because the self-rental entity has common ownership (100%) and is exclusively renting property to OpCo, the income from RentCo will be SSTB income for K and will not be QBI income for purposes of the QBI deduction.

Tax planning opportunities

Although the self-rental rules can place an unanticipated burden on taxpayers, they also create opportunities for tax practitioners to provide planning advice of immense value. The following examples illustrate some of the tax planning opportunities that can arise from the self-rental rules.

First, it is important to take stock of the taxpayer’s entire tax situation. If a taxpayer regularly has net passive income from other sources that can be used to offset passive losses, the self-rental rules may benefit the taxpayer, because the self-rental income, which is considered active income, would not be subject to NIIT. In contrast, most other passive income from rental activity would be subject to NIIT.

Example 3 (passive income from other sources): J operates a grocery store through a wholly owned S corporation (OpCo). He owns the building and land associated with the grocery store in a separate S corporation (RentCo), which rents the building and land back to OpCo. J receives a $250,000 salary from OpCo and is allocated an additional $100,000 in ordinary business income. RentCo produces $50,000 of income allocable to J, and he has $25,000 of passive income from other activities, which is excluded from the definition of qualified trade or business in calculating QBI.

In this situation, J does not need to use the self-rental income to offset any passive loss. He has $400,000 of active income ($250,000 + $100,000

$50,000), of which $150,000 ($100,000 + $50,000) is QBI income for purposes of the QBI deduction and not subject to NIIT because it is considered nonpassive income. He also has $25,000 of passive income, likely subject to NIIT. Next, although the IRS will scrutinize that the amount of rent paid to a self-rental entity is paid at fair rental value, taxpayers have substantial discretion in determining the amount of deduction in the rental entity. This feature gives taxpayers the ability to change the amount of income or loss in their discretion. A major source of deduction discretion lies in the 100% deduction for bonus depreciation made available by the TCJA. Even though the bonus depreciation deduction is phasing out by 20% each year through Jan. 1, 2027, when it fully phases out, it still, for a time, provides significant amounts of deduction relative to the cost of the items.14

For instance, rather than renting only the land and building, a taxpayer may choose to acquire certain furniture, fixtures, and equipment in the rental entity to adjust the amount of income or loss recognized by that entity. This strategy presents an opportunity when there is a discrepancy between the marginal tax rate of the rental entity income and the operating entity income (e.g., when a taxpayer with a high marginal tax rate owns a rental entity and the operating entity is organized as a C corporation).

Example 4 (the effects of bonus depreciation): In 2023, K, a pediatrician, operates his physician practice through a wholly owned C corporation (OpCo). He owns the building and land associated with the practice in a separate S corporation (RentCo), which rents the building and land back to OpCo. K receives a $350,000 salary from OpCo. RentCo produces $50,000 of income allocable to K before depreciation on $60,000 of newly acquired furniture. K’s marginal tax rate is 37% (i.e., assuming K has other income that would push him to this marginal tax rate).

In this situation, K benefits from purchasing the furniture in the rental entity, because his marginal tax rate on income from RentCo is 37%. The $60,000 in furniture, with a seven-year useful life, using a half-year convention, produces a depreciation deduction of $49,715 ([$60,000 × 80%] + [$12,000 × 14.29%]), which reduces his self-rental income to $285 and produces tax savings of $18,395 ($49,715 × 37%). Had he purchased the furniture in OpCo, he would have realized tax savings of only $10,440 ($49,715 × 21%).

Finally, taxpayers engaged in self-rental activities may consider implementing a grouping election to pair the self-rental activity with that of the operating entity. Grouping allows taxpayers to combine what would be passive loss from a self-rental entity with income from an operating entity, so it can be beneficial, given that fact pattern. Under Regs. Secs. 1.469-4(d)(1)(i) (A)–(C), rental activities can be grouped with other activities if they constitute an appropriate economic unit and:

  • The rental activity is insubstantial in relation to the trade or business activity;
  • The trade or business activity is insubstantial in relation to the rental activity; or
  • Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

Thus, provided there is proof that either the rental activity is insubstantial to the operating activity or the ownership is the same, taxpayers can take advantage of a grouping election to utilize the losses from the self-rental activity. This strategy can be particularly beneficial if the taxpayer does not have any other passive income.

However, Regs. Sec. 1.469-4(e) states that a taxpayer must continue to use the groupings established unless there is a material change to facts and circumstances that renders the current grouping inappropriate.

Importantly, the grouping election must be on the first tax return filed, because treating the self-rental activity and operating activity as separate is deemed a grouping choice under Regs. Sec. 1.469-4. The permanence of the grouping election emphasizes that taxpayers should carefully consider the typical facts and circumstances of each entity before pursuing a grouping election. For operating entities that are not SSTBs, the grouping election can also aid in maximizing the benefit of the QBI deduction.

Example 5 (grouping elections): In 2023, J operates a grocery store through a wholly owned S corporation (OpCo). He owns the building and land associated with the grocery store in a separate S corporation (RentCo), which rents the building and land back to OpCo. J receives a $250,000 salary from OpCo and is allocated an additional $100,000 in ordinary business income. RentCo produces $50,000 of loss allocable to J, and he has $25,000 of passive loss from other activities.

In this situation, J cannot utilize any of the passive loss because he has no passive income to offset it. He has $300,000 of active income ($250,000 + $100,000 – $50,000), of which $100,000 is eligible for a QBI deduction and not subject to NIIT because it is considered active. J can use the $50,000 in loss from RentCo to offset OpCo’s income due to the grouping election. The $25,000 of other passive loss is still suspended under the Sec. 469 passive loss rules.

Avoiding unanticipated results

Collectively, the self-rental rules present a complicated but relevant challenge to many taxpayers. Careful consideration of the facts and circumstances, including the effects on owners who do not materially participate in the operating entity, will substantially reduce the potential for unanticipated results.

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