Beware the Self-Rental Trap
Passive activity loss rules mean landlords can't deduct rental losses like other businesses can offset their business losses from income.
Are you a landlord who has rental losses? A rental loss occurs if the expenses from your rental activities exceed your income for the year. Rental losses are common, especially in the first few years a property is operated as a rental.
A loss of any kind can help save you taxes if you can deduct it from other income you have for the year. Unfortunately for landlords, however, there are strict limits on deducting rental losses from non-rental income such as income from a job or business or investment income.
Complex rules known as the passive activity loss rules provide that all income and loss from rental activities is automatically passive income and loss. This means that, subject to some important exceptions, rental losses can only be deducted from other passive income.
Without sufficient passive income, your rental losses become suspended losses you can't deduct until you have sufficient passive income in a future year or sell the property. You may not be able to deduct these losses for years.
In short, your rental losses will be useless without offsetting passive income.
Unfortunately, passive income can be hard to come by. There are only two sources:
- net income from a rental activity, or
- net income from a business in which you don't materially participate (you materially participate in a business only if you are involved with its day-to-day operations on a regular, continuous, and substantial basis--for example, you work in it over 500 hours per year).
The most common way to earn passive income is from real estate rentals. Of course, you must be fortunate enough to own rental real estate that earns a profit to have passive rental income. If you rent real estate to an unrelated third party and end up with a profit, you'll have passive income you can use to offset passive losses from other properties with no trouble from the IRS.
However, one way you cannot generate more passive income to absorb your rental losses is to rent your property to a business you own or materially participate in.
The IRS has created a special self-rental rule that automatically takes effect whenever you rent property to your business. Under these rules, any net rental income you receive from renting property to a business in which you materially participate is characterized as nonpassive income that can't be used to offset any passive losses you have--for example, losses from other real estate rentals you own.
EXAMPLE: Gary and Dolores Beecher are a married couple who owned two corporations engaged in the business of repairing automobile interiors and exteriors. They also owned five rental properties that resulted in substantial annual losses. The Beechers had a great idea: because they worked out of their home, they would lease their home office to their corporation. They would use this lease income—ordinarily, passive income—to offset the losses from their rentals. As a result of this combination of income and losses, the Beechers paid no tax on the rental income paid to them by their corporations—this amounted to over $85,000 of tax-free income over three years. Unfortunately, the IRS audited the Beechers and recharacterized their rental income from their corporations as active, not passive, income. Thus, it could not be used to offset their rental losses. Under the self-rental rule, income from the rental of property for use in a trade or business in which the taxpayer materially participates is treated as nonpassive income. The courts upheld the IRS’s ruling.
Obviously, one way to avoid the self-rental trap is to not rent property you own to any business in which you materially participate. If you can do this at a profit--a big if--you'll have passive income you can use to offset passive losses.
Alternatively, you or your spouse could qualify as a real estate professional. In this event, you can deduct all your rental losses each year (to be a real estate professional, you or your spouse must spend more than 751 hours a year working in one or more real property businesses, and this time must amount to over half your working hours during the year).
Finally, you can avoid the problem altogether by not incurring substantial rental losses year after year. You could sell some or all of your loser properties. This way you won't be in need of passive income.
For more details on deducting losses from rental properties, see Fishman, Every Landlord's Tax Deduction Guide (Nolo).