Long ago, there was no tax code that differentiated ordinary income from passive income or ordinary losses from passive losses. Life was good for taxpayer’s and their CPA’s in the know. People freely set up tax shelters to reduce their taxable income while still navigating within the laws of the IRS. Primarily by reducing their ordinary income with passive losses.
Most of the CPA’s practicing back then have probably long since retired, and tax law has since changed considerably. And not for the benefit of the taxpayer.
Fortunately, one of these tax shelters still exists. One that lets you turn a passive loss into an ordinary loss by utilizing a self-rental property. But before we fall down the rabbit hole, lets brush up on some history for more context.
Passive Loss History
When I said long ago, I meant 1986. This is when US Code § 469, Passive Activity Losses and Credits Limited, was passed. The statute defines passive income as rental real estate and any activity in which a taxpayer doesn’t materially participate in. They closed the loop hole, sort of.
There was still no statutory rule for self-rental real estate, and taxpayers were using self-rental income to absorb other passive losses. And owners could optimize their self-rental income either up or down to take 100% of their passive losses that otherwise would be unutilized and carry forward. This carried on until 1992.
Regulation 1.469-2 came out and stipulated rental income is not passive if it comes from an activity a taxpayer materially participates in. This is known as the self-rental trap. Income from a self-rental now becomes ordinary income and rental losses remain passive. And this makes using a self-rental as a tax shelter very difficult.
Example 1 of the Self-rental Loophole
Lets go through a simple example to show why this can be so problematic.
Jennifer owns 100% of her own law firm, taxed as an S Corporation. She also co-owns a building and rents the whole building to her law firm. At the end of the year, her law practice has $200,000 of net income and her portion of the rental loss is $50,000.
You would assume she can net the two amounts and pay tax on $150,000, but that’s not how it works. She has a passive loss of $50,000 that she cannot take because she has no other passive income. Ultimately, she has $200,000 of taxable income.
Jennifer has net income from the law firm of $250,000, her portion of the self-rental loss is $50,000, and she purchased a single family residence she rented out with net income of $20,000.
She is able to net the $20,000 of rental income with $20,000 of loss from her self-rental (because self-rental losses are passive). She still cannot take a self-rental loss because she has extinguished her passive income.
Her net income is equal to the $250,000 from the law firm, and her loss carryforward is now equal to $80,000; $50,000 from year 1 and $30,000 from year 2.
As you can see, Jennifer isn’t benefiting from her self-rental since she cannot take the losses. But lets look at another way she can do this.
Grouping your Active Trade or Business with your Self-rental
Regulation 1.469-4 that allows similar activities that constitute an appropriate economic unit to be grouped as a single activity for purposes of the passive activity loss rules. The taxpayer may use any reasonable method in grouping activities by applying the relevant facts and circumstances, and the regulation gives the most weight to these 5 factors:
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location;
- Interdependencies between or among activities
Typically you are not able to group rental activities with other trade or business activities. However, you can if the rental activity and business activity constitute an appropriate economic activity, AND:
- The rental activity is insubstantial in relation to the trade or business activity;
- The trade or business activity is insubstantial in relation to the rental activity; or
- Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.
Once you have determined you can group your rental activity with your business activity, Rev Proc 2010-13 says you need to file a grouping statement with your tax return.
In summary, the statement must identify the names, addresses, and employer identification numbers (if applicable) for the trade or business activities or rental activities that are being grouped as a single activity. You must declare the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Section 469.
Example 2 of Self-rental Loophole
In our example earlier, Jennifer wasn’t a 100% owner in her law firm AND her self-rental property. Lets go back to that example assuming she owns 100% of both and makes a grouping election on her tax return.
Jennifer owns 100% of her own law firm, taxed as an S Corporation. She also owns 100% of a building and rents the whole building to her law firm. At the end of the year, her law practice has $200,000 of net income and her rental loss is $50,000.
Now she gets to net the rental loss with her business income and has taxable income of $150,000. Assuming her marginal tax rate is 32%, this saves her $16,000 in taxes compared to our earlier example!
Jennifer has net income from the law firm of $250,000, self-rental loss of $50,000, and she purchased a single family residence she rented out with net income of $20,000.
First, she nets the rental loss with her business income, for a total of $200,000. Assuming she doesn’t have any passive losses, she picks up another $20,000 of taxable income from the new rental, for total taxable income of $230,000.
The increased income in year 2 puts her marginal rate at 35%. Since her taxable income is $20,000 less than the previous example, her tax savings equal $7,000!
A Trick for Bigger Rental Losses
Your business is doing well and you know you will have record net income, and also record income taxes. Fortunately, you already have a self-rental and have been converting the losses from passive to ordinary because you made a grouping election. Now this idea, do a cost segregation.
A cost segregation breaks down real property, which is depreciated over 39 years, into personal property, which is often depreciated entirely in one year.
A building with a depreciable basis of $500,000 might accelerate up to $150,000 of depreciation in one year. That is adding a $150,000 deduction to a return, and a tax savings of probably more than $50,000!
It is a great way to load up deductions and offset business income in a windfall year.