For small business owners and entrepreneurs, understanding the self-rental tax strategy is essential to maximize tax benefits. Self-rental arrangements, where you lease a property that you own to your business, can make a big impact on your tax liabilities. It can also help you to grow equity in your assets over time. This article will break down all the key points you need to know about renting property to your business – from setting a fair rental price to using grouping elections and cost segregation. This will help you to grow your business while staying out of tax trouble.
Key Takeaways
- Self-rental income is classified as active, which means it can’t be used to offset losses from passive activities.
- Losses from self-rentals are classified as passive, so they can only be used to offset other passive income, limiting their immediate tax benefit unless a grouping election is made.
- Working out a fair rental value for the property and keeping accurate records is essential to avoid any run-ins with the IRS.
- If you’re actively involved in the running of your rental property, it’s possible to change the way the income is treated, which can cut your tax bill.
What is Self-Rental Property?
Self-rental is all about owning real estate in one company and renting it to a business you own through another company. This triggers some specific tax rules that affect how you report rental income and losses.
For example, let’s talk about Dr. Smith, a dentist who owns his dental practice through one company (DentalCo). He also owns the building where the practice operates, but this building is owned by a separate company (RentCo). Every month, RentCo charges DentalCo rent for using the building. Since Dr. Smith owns both companies, this is a self-rental arrangement.
Self-rental properties are particularly common in businesses like medical and dental practices, law firms, therapy practices, small manufacturing companies, veterinary clinics, accounting firms and architectural firms.
Understanding Self-Rental Rules
In general, rental activities are considered passive activities. The passive activity loss rules generally limit the ability to deduct losses from passive activities against active income. Passive losses from real estate may only offset income from other passive activities. Generally, passive losses may not be used to offset income from wages or other active businesses.
Self-rental arrangements, however, fall under a different set of self-rental rules. Self rental refers to situations where an individual owns property through one entity and rents the property to another business that they own in a different entity. The key tax differences with self-rental properties are:
- The income from self-rental properties is classed as active income, not passive income, which means you can only use it to offset losses from other active businesses.
- However, losses from self-rentals are classed as passive – which means you can only use them to offset other passive income.
- When the property owner and the rental company are the same person or company, these rules mean that you can’t offset passive and non-passive income, which makes it really important to think about how you structure your business and what you charge for rent.
Therefore, unless you make the election described below, passive losses from your self-rental property may not offset active income from your business that is renting the property. This will limit the immediate tax benefits of depreciation deductions from cost segregation studies and other tax planning strategies that are popular among business owners and entrepreneurs.
Self-Rental Rules Save on Net Investment Income Tax
An advantages of self-rental income being classed as active income is it’s exempt from the 3.8% Net Investment Income Tax (NIIT). Normally, rental income is considered passive and subject to NIIT, which taxes certain net investment income that exceeds specific income thresholds.
However, because these rules classify self-rental income as active income, it isn’t included in the NIIT calculation. This means you get to keep more of your tax savings if you rent your property to a business that you own.
Grouping Election Offers Key Tax Benefit for Business Owners with Self-Rented Property
Fortunately, the grouping election offers a valuable workaround to the limitations imposed by the self-rental rules. Under the grouping rules of Treasury Regulation §1.469-4(d), taxpayers are allowed to combine self-rental and operating activities into a single economic unit for tax optimization.
This means that losses from your self-rental property can now be used to offset income from your operating business. This election overcomes the usual limitation where self-rental losses are classed as passive which cannot be used to offset active income. As a result, the grouping election can lead to significant tax savings.
The grouping election requires common ownership of the rental property and the operating company. When the taxpayer owns the same proportionate ownership interest in both the rental real estate and the operating entity, the IRS is more likely to consider these activities as part of the same appropriate economic unit.
Example of Grouping Election
Let me give you an example of how the grouping election can work for you:
Jane owns two entities – a veterinary clinic structured as an S corporation (OpCo) and a separate rental entity (RentCo) that owns the building OpCo rents from her. Jane is heavily involved with the business. Under the self-rental rules, the rental income RentCo receives from OpCo is classed as non-passive income, while any losses RentCo incurs remain passive.
Without the grouping election, Jane cannot offset RentCo’s passive losses against the active income from OpCo. This separation limits her ability to fully use her rental losses, which will be suspended for use against future passive income.
However, if Jane makes a grouping election under Treasury Regulation §1.469-4(d), she can combine the rental activity of RentCo with the operating business activity of OpCo into one economic unit. When grouped this way, the rental and operating activities are considered one self-rental activity for tax purposes. This allows Jane to offset losses from RentCo against the income from OpCo, reducing her overall tax burden.
Cost Segregation and Self-Rental Strategy
Cost segregation is a powerful strategy for business owners with self-rental properties. This strategy allows property owners allocate costs to shorter-lived categories for depreciation, which brings a tax saving boost. The cost segregation strategy accelerates depreciation, generating upfront deductions that reduces taxable income. By combining cost segregation with self-rental grouping, business owners can minimize their taxes overall.
Moreover, the use of 100% bonus depreciation can further reduce current tax liability. Bonus depreciation allows taxpayers to immediately expense qualified property, enhancing tax savings in self-rental situations. Cost segregation combined with a self-rental strategy leads to optimized overall tax liabilities and improved cash flow.
Example of Cost Segregation Using a Self-Rental Property
Take Samuel, for example. Samuel owns a marketing firm (OpCo) structured as an S corporation and a separate rental entity (RentCo) that owns the building OpCo leases. Since Samuel materially participates in the operating business, the rental income received by RentCo is treated as non-passive for tax purposes. RentCo recently bought some new machinery and equipment for $100,000 to go in the building.
By doing a cost segregation study, Samuel finds out that $40,000 of the purchase qualifies as personal property with a 5-year depreciation life, and the rest is structural and would take 39 years to depreciate. Thanks to cost segregation, Samuel can speed up the depreciation on that $40,000 portion and claim a bigger deduction in the early years.
Since RentCo is a self-rental entity, the rental income it gets from OpCo is treated as active income – and that means it’s exempt from the Net Investment Income Tax. But if RentCo does have losses, they will be passive unless Samuel makes a grouping election to combine RentCo and OpCo activities.
If Samuel doesn’t make the election, the accelerated depreciation deductions from RentCo are passive losses and won’t be able to offset OpCo’s active income, which limits the immediate tax benefits. But if he does make the election, those passive losses will offset OpCo’s active income, which maximizes overall tax savings.
Material Participation in Self-Rental Activities
The self-rental tax strategy described above requires material participation. This means that the business owner must meet specific tests, such as participating in the business for over 500 hours in a year or having substantial participation relative to others involved in the activity.
How Much Rent May I Charge When Renting to My Own Business?
Finding a fair rental price is important when it comes to self-rental scenarios. If the IRS thinks the rent you’re charging isn’t at fair market value, they can step in and adjust it. This will impacts both the rental entity and the business that is renting the property from you. Both the rental entity and the business must make sure that the rent they’re paying each other reflects fair market value in order to stay out of IRS trouble.
Procedure for Self-Rental Grouping Election
To make this election, taxpayers need to attach a clear and concise election statement to their timely filed tax return for the year they make the election. This statement needs to identify the activities being grouped – usually the self-rental activity and the operating business – and affirm that these activities make up an appropriate economic unit under Treasury Regulation §1.469-4(d). The election statement needs to explicitly say that the taxpayer intends to group these activities for tax purposes.
Once the election is made, it’s generally binding for future years unless there’s a material change in facts and circumstances that would justify changing it. Proper documentation and timely filing of the election statement are super important to ensure the IRS recognizes the grouping and lets the taxpayer treat the combined activities as non-passive – and that lets them maximize the tax benefits.
Non-Tax Benefits of Self-Rentals
It’s not just tax advantages – self-rentals offer non-tax benefits as well to business owners.
First, separating real estate ownership from the operating business can provide liability protection. By holding the property in a separate entity, business owners can shield the real estate assets from potential lawsuits, creditor claims or other liabilities arising from the operating business. This separation reduces the risk that issues in the operating company will jeopardize valuable real estate holdings.
Second, self-rentals can make it easier for purposes of succession planning. Owning the property separately makes it easier to transfer or sell the operating business without having to transfer the real estate. This can simplify transactions and create opportunities for estate planning, where ownership interests in the real estate entity can be gifted or bequeathed independently.
Third, self-rentals can give business owners better control over their finances. With separate entities, they can clearly track the profitability of the operating business distinct from the real estate investment’s performance. This clarity helps with budgeting, forecasting and making informed decisions about each component of the overall business.
And on top of all that, self-rental arrangements may provide opportunities for better financing terms. Lenders often view real estate held in a separate entity as a distinct asset, which can be leveraged independently of the operating business’s cash flow or creditworthiness. This separation can enable business owners to get loans or lines of credit specifically for the real estate entity, potentially at favorable rates.
Another benefit of self-rental strategies is the chance to build equity in real estate, rather than giving that money to an external landlord every month. By owning the property, business owners are putting their money into an asset that can actually increase in value over time, thus boosting their net worth.
Finally, self-rental structures may make it easier to comply with certain regulations or contractual obligations. For instance, some operating businesses may have rules that say they can’t own certain assets or they need to get special insurance – matters that are easier to manage if the property is held separately.
Summary
Self-rental tax strategies are a powerful tool for business owners looking to optimize their tax situation and free up some cash flow. It’s not always easy, but getting a handle on the self-rental rules, making sure you’re classifying income correctly, using grouping elections to your advantage, and understanding cost segregation are all crucial steps. Material participation, common ownership and careful planning all help to get the most out of these strategies.
Using these strategies effectively means you can confidently navigate the tax landscape and make the most of your rental activities. Whether you’re just starting to explore self-rental strategies or looking to refine what you’re already doing, this guide should give you the insights you need to succeed.
Frequently Asked Questions
What are self-rental rules?
The self-rental rules are the tax regulations that say how rental income and losses from properties owned by a taxpayer in different entities are classed and taxed. You need to stick to these rules if you want to get your tax treatment right.
How is self-rental income classified for tax purposes?
For tax purposes, self-rental income is classified as active income – which means it can’t be used to offset losses from passive income and is exempt from the Net Investment Income Tax.
What is a grouping election, and how can it benefit me?
A grouping election lets you combine rental and operating business activities for tax purposes – which usually results in a lower tax cost overall.
How does cost segregation impact self-rental strategies?
Cost segregation is a real game-changer for self-rental strategies. It lets you accelerate depreciation on the shorter-lived assets of a property, which can improve cash flow and minimize taxes.
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