If you own both property and a business, it just makes sense to lease the property to your business, right? Not always—this approach could be costly tax-wise, especially in light of the 3.8% net investment income tax (NIIT) now imposed on certain passive income. Fortunately, there may be a way to avoid these undesirable consequences.
The Self-Rental Rule
The self-rental rule applies when you rent property to a business in which you and/or your spouse “materially participate.” The rule treats rental income as non-passive but rental losses as passive. A taxpayer materially participates in a business if he or she works on a regular, continuous and substantial basis in its operation.
Unfortunately, the Internal Revenue Code generally prohibits taxpayers from deducting passive losses. A passive loss can usually offset only passive income, meaning income from a business in which you do not materially participate, or rental real estate in which you do not actively participate. “Active” participation is a less stringent standard than “material” participation. The active participation rules provide for limited circumstances under which you will be able to deduct passive losses; typically, though, absent passive income you may not claim current deductions for passive losses.
On top of that bad news, higher-income taxpayers generally will be subject to the NIIT on some or all of their unearned income, including rental income. This is in addition to (and calculated separately from) the taxpayers’ regular income tax or alternative minimum tax liability.
An Alternative Approach
You might be able to avoid the negative self-rental rule results by electing to “group” your business activities and rental activities for purposes of the passive loss rules, if both activities together constitute “an appropriate economic unit.”
The factors given the greatest weight when determining whether a group is an appropriate economic unit are:
- Similarities and differences in types of businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependencies between or among the activities.
The interdependencies factor might consider, for example, the extent to which the activities purchase or sell goods to each other; involve products or services that are normally provided together; have the same customers or employees; or are accounted for with a single set of books and records.
Proceed with Caution
If you qualify for the grouping election, you could offset your business’s non-passive income with the otherwise passive rental losses. The rules for grouping are complicated, however, and include conditions beyond the appropriate economic unit requirement. Your tax advisor can help you chart the best course forward to minimize your taxes.
For more information, contact Adam Levine at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.