Avoiding the Self-Rental Trap
Why tax practitioners should make themselves aware of the many exceptions to the general rules under Section 469 and how to take advantage of the potential opportunities.
by Anthony Constantine/The Tax Adviser
Navigating the passive activity loss rules can be a daunting task at times. Many taxpayers do not really understand the rules or the potential impact they can have on transactions and investments. There are nuances that, if not addressed ahead of time, can have significant negative tax implications.
One of those nuances is the treatment of self-rentals under the passive activity loss rules. Many practitioners are aware of the self-rental rules, but there is a situation that may create an unintended limitation.
What Is a Passive Activity?
Sec. 469(c) provides that a passive activity is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Sec. 469(c)(2) states that passive activity includes any rental activity.
Material participation is not clearly defined in the Code. Sec. 469(h)(1) provides that a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the activity's operations on a basis that is regular, continuous and substantial. This is a facts-and-circumstances determination, but there are temporary regulations that provide much more detailed guidance for making a clear determination of material participation.
The taxpayer's participation must meet certain standards. Activities not customarily done by an owner or activities of an investor do not qualify. The taxpayer's activity must be that of an active owner directly involved in the day-to-day management of the activity.
What Happens in a Self-Rental Situation?
Many taxpayers that own an operating company also own accompanying real estate. The building and land may be owned in a separate entity for a variety of reasons. If the operations and the real estate are in separate entities, how is the flow-through income or loss treated under the passive activity loss rules? If the operating company is an entity that the shareholder actively participates in on a day-to-day basis, in most cases the shareholder would be considered to materially participate in this activity. The general rule is that rental real estate is a passive activity. There is one exception for certain real estate professionals; another is the self-rental rule. So does simply having the two activities in separate entities cause different treatment under Sec. 469 than owning the real estate in one entity?
The answer is yes. Temp. Regs. Sec. 1.469-2T(f)(6) covers the treatment of self-rental transactions. It provides that an amount of the taxpayer's gross rental activity income for the tax year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property is:
What would ordinarily be considered income from a passive activity is treated as non-passive income because the owner materially participates in the operating-lessee entity. This rule would seem to put taxpayers who place the real estate used in their trade or business in a separate entity on an equal footing with taxpayers who retain the real estate in the same entity as the business operations. Since the income (or loss) from the business operations would be non-passive, it seems justified that income "siphoned off" to the real estate activity should also be non-passive. However, this provision does not cover any loss that may arise from the rental activity. Under the self-rental rule, the rental losses are still considered to be passive losses deductible only to the extent of passive income, while the income is treated as "active income" (Carlos, 123 TC 275 (2004)).
Trap 1 — Trapped Losses
Taxpayers must pay close attention when using a self-rental transaction. Assume that the taxpayer has a loss on the rental of property to a business in which he or she materially participates. That loss is subject to the passive loss rules so, absent any other passive income in the current year, the loss will not be deductible but suspended and carried forward to future tax years. This is the case even though the taxpayer may have income from the activity to which he or she rents the property. In the subsequent year, if the taxpayer has net rental income from the property rented to the related activity in which the taxpayer materially participates, then the income is considered to be active income.
This active income can be offset by the suspended passive losses from the activity; however, it cannot be offset by passive losses from other activities. If the taxpayer was planning to shelter a portion of his or her income through the use of a self-rental arrangement with losses from other passive activities, the taxpayer has fallen into the self-rental trap. Also, if the taxpayer was planning to use losses generated by the rental activity to offset income from the operations of the active business, he or she has again fallen into the self-rental trap.
In the second instance, the easy fix would be to combine the rental activity with the operations activity either via an actual legal merger or by making an election to aggregate the activities. The taxpayer can only make the election to aggregate the activities in the initial year the taxpayer reports the activities. This election requires the attachment of a formal statement to the return.
A legal merger can be accomplished in various forms and at various times, each with its own tax ramifications, which are outside the scope of the item.
Trap 2 — Sale of Operating-Lessee Company With Real Estate Retained
Can a taxpayer avoid the self-rental trap after the sale of the operating-lessee company? It is quite common for a middle-market company to sell the operating business (or assets of the business) but retain the real estate associated with that business. Subsequent to the sale, the seller will continue to lease the property to the buyer operating the now-unrelated business.
Typically, as part of the overall transaction, the seller will renegotiate the lease of the real estate, if previously held outside the operating entity, or enter into a lease, if previously held as part of the operating business, with the new buyer. The new lease, which the seller negotiates at arm's length, generally will create positive cash flow to the seller and net rental income. Often the seller (and his or her advisers) believe that this income (from a rental activity with an unrelated third party) will create passive income that can be sheltered by other passive losses that the seller has or intends to generate in years after the sale has occurred.
The self-rental rule described above says that if the taxpayer materially participates in an activity, then the net rental income generated from the rental of property to the activity will be treated as nonpassive (active) income. The taxpayer in this case is no longer involved in the business; however, under the material participation rules outlined above — specifically, Temp. Regs. Sec. 1.469-5T(a)(5) — if the taxpayer has materially participated in an activity for 5 out of the past 10 tax years, then the taxpayer is considered to have materially participated in the current year. Thus, where the operating business remains a "separate activity" in the buyer's hands, the taxpayer will continue to be a material participant in the activity after it is sold under the 5-out-of-10-year rule until the expiration of that period. It is important to remember that under the passive activity rules, in order to be considered a separate activity, the operating business does not have to be a separate entity.
Since the taxpayer was planning on sheltering his or her rental income with other passive losses, the taxpayer has again fallen into the self-rental trap. The other passive losses that the taxpayer has or will be generating will be unusable against the rental income for a period of at least five years from the date of sale. If the real estate is sold during this period, any gain on the sale will also be considered income from self-rented property and therefore active.
Transactions that may be subject to the passive loss rules should be carefully scrutinized. Often what seems to be a simple matter is fraught with exceptions that can cause havoc to good tax planning. Tax practitioners should make themselves aware of the many exceptions to the general rules under Sec. 469 and the potential opportunities to plan around or make advantageous use of them. The self-rental trap is only one example of the many exceptions in these rules buried within the regulations and temporary regulations. Careful analysis can often avoid costly mistakes.
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G. Edgar Adkins, Jr., CPA/M. Acc., is Partner, National Tax Office, Grant Thornton LLP, Washington, DC. Adkins is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.