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As a business owner, renting property to your own business might seem like a straightforward strategy. However, without proper tax planning, this approach can lead to significant tax implications, often referred to as the “self-rental trap.” Understanding how to navigate this situation is crucial for optimizing your tax outcomes and avoiding pitfalls.
The Self-Rental Trap: Understanding the Basics
When you rent a property that you own to your own business, the rental income is considered nonpassive. This classification is problematic because nonpassive income cannot offset any passive losses you might have from other investments. On the other hand, rental losses from the property are deemed passive, which often means they cannot be deducted in the year they occur. In short, this scenario gives you the worst of both worlds: taxable income without the benefit of offsetting losses.
The Solution: Grouping Activities
Fortunately, there is a way to avoid this trap through the IRS’s special grouping rules. If you own both the rental property and the business, you may be able to group these two activities as one for tax purposes. This grouping allows you to offset the rental property’s passive losses against the active income of your business, effectively lowering your taxable income.
To qualify for this strategy, you must own the same proportionate interest in both the rental property and the business. Whether you hold these assets as an individual, through an S corporation, or an LLC, this grouping strategy can be applied. However, it’s essential to note that this approach does not work if your business is structured as a C corporation.
Real-World Example: Harvey and Wilma Johnston
Consider the case of Harvey and Wilma Johnston. Harvey owns an S corporation that operates his dental practice, while Wilma owns a single-member LLC that holds the building rented to Harvey’s practice. Because they file a joint tax return, the IRS treats them as a single taxpayer. By electing to group the dental practice and the rental property as one activity, the Johnstons can offset the rental property’s losses against the dental practice’s income, reducing their overall taxable income.
This strategy becomes even more beneficial if personal property, such as appliances, is included in the rental. In such cases, there’s no need to separate the personal property from the real property rental when making the election.
The Importance of Formal Election
To take advantage of the grouping rules, you must make a formal election and notify the IRS. This election should be attached to your tax return and must include details such as the names, addresses, and employer identification numbers of the business and rental activities you are grouping.
Special Considerations for Business Owners
While the grouping strategy offers significant tax benefits, there are some nuances to consider:
- Personal Property Grouping: Typically, you cannot group personal property and real property rentals. However, if the personal property is included as part of the real property rental, it can be grouped without a separate breakout.
- Partial Ownership: If the rental property is partially rented to third parties, only the portion used by the commonly owned business can be grouped. The remaining portion must be treated as a separate rental activity, subject to the passive loss rules.
- C Corporations: The IRS explicitly prohibits the grouping of rental activities with a C corporation. This rule means that if your business is structured as a C corporation, you cannot benefit from the grouping election.
Final Thoughts
Renting property to your own business doesn’t have to lead to unfavorable tax consequences. By understanding and utilizing the IRS’s grouping rules, you can avoid the self-rental trap and optimize your tax situation. Always ensure that you consult with a tax professional to properly execute the election and navigate the complexities of self-rental arrangements.
For further information, you can refer to IRS regulations, including Reg. Section 1.469-4 and Revenue Procedure 2010-13, which outline the detailed requirements and procedures for making this election.
