Avoiding the Self-Rental Trap
[Ed note: WS+B Tax Supervisor Sara Palovickstops by to warn taxpayers of a trap for the unwary: the self-rental rules of Section 469. Now, on to Sara: ]
Taxpayers must be aware that if they have self-rental activities with net income, the income from these properties will be recharacterizedas nonpassive income under Reg. 1.469-2(f)(6). Self-rented property is property that is rented or used in a trade or business activity in which the taxpayer materially participates.
To illustrate, if individual B is a passive investor in a limited partnership that allocates to B a $10,000 loss, B can only use the loss to the extent he has passive income from other sources. In an attempt to generate passive income, B rents a building he owns personally to an S corporation in which B materially participates, generating $10,000 of rental income.
Though the default rule of Section 469 requires treating all rental activity as passive, the self-rental rules trump this general requirement and treats B’s $10,000 of rental income as nonpassive. As a result, A cannot offset the $10,000 passive loss from his limited partnership with the $10,000 of rental income.
Self-rental rules recharacterizerental income by items of property, rather than activities. In Joseph Veriha, 139 T.C. 3 (2012), the Tax Court reclassified income from each tractor/trailor owned by the taxpayer into separate items of property, causing any rental income to be classified as nonpassive while any rental losses retained their passive nature.
The self-rental rules apply regardless of whether the entity to which the property is being rented is a C corporation, S corporation, or partnership. As a result, any time an individual owns property thatis leased to an entity in which the individual materially participates, the rental income may be recharacterizedas nonpassiveincome. Having a bona fide business purpose does not eliminate the application of the self-rentalrules. Regardless of the business purpose and fair market value of the rent, the court has ruled that the recharacterizationrules apply. The only exception to the self-rental recharacterization rules are for binding written rental contracts that were entered into before February 18, 1998.
