If you rent property to one of your own businesses, you may accidentally catch the eye of the IRS. Although rental real estate properties are generally treated as passive activities, the self-rental rules may recharacterize the rental income as non-passive in some cases. That is exactly what happened to one investor who leased property to his wholly-owned S corporation.  The IRS applied the self-rental rules to his passive rental income and decided to recharacterize the rent as non-passive income, which meant that any other passive activity losses from rental real estate could not offset the profitable rentals.  The investor decided to challenge the IRS and eventually won the case.

The IRS View of Self-Rental Rules

The investor disputed the IRS and appealed the decision in Tax Court.  The Tax Court found that the self-rental rules did not apply and the IRS could not recharacterize the rental income as nonpassive.  The investor was engaged in a variety of radio-related activities, including construction of and leasing access to telecommunications towers, sales and servicing of radios, and also selling services and constructing towers leased to customers.  The investor reported his income for all of the years as ordinary, but reported the rental losses from his leases as a passive rental activity.

The IRS applied the self-rental rules to recharacterize income from profitable rentals of towers and/or land as nonpassive income, meaning that the passive activity losses from non-profitable rentals could not offset the profitable rentals.  The self-rental rules apply to net rental income if the property is rented for use in “a trade or business” (which is any activity other than a rental activity) in which the taxpayer materially participates.

The Tax Court Disagrees with the IRS

The IRS contended that the rental activity must be considered part of its overall trade or business activity.  It relied principally on the grouping of all of the activities and reporting of related income as nonpassive ordinary business income on the tax returns each year.  The IRS claimed that the investor was bound by this characterization — not only for his share of business income — but also for his rental income.

However, the Tax Court found there was a mischaracterization of its rental income from third parties (as ordinary business income), and that mistake did not control the application of the self-rental rules when that rule was not applicable — because the towers were really unrelated to another trade or business.  It held that leasing of towers to third parties was clearly a rental activity.  Therefore, the self-rental was related to another passive activity.

Self-Rental is More Important than Ever

The new 3.8% tax on net investment income, which applies to certain passive income, makes it more critical than ever for taxpayers to properly identify their passive activities. The owner of passive activities has many tax decisions to make regarding the grouping and structuring of real estate and leasing activities.  Asking a tax advisor to review the tax costs and structure of passive activities now can save you a lot of tax dollars in the future.

If you would like additional information, please contact Tom Kosinski at [email protected] or call 312.670.7444.