I know that you are thinking about buying a building and renting space to your business.
When you do this, you enter a special area of tax law that I will call the “self-rental trap.”
Rental activities occupy their own section of the tax code, and much of it is not pretty. Here’s the overall rule, which you likely know: rental activities are passive activities.
And you likely know that you have a number of hurdles you need to jump before you can deduct your passive losses.
But did you know that the tax code imposes even higher hurdles when it comes to a self-rental? Here’s what happens when business owners rent property to businesses in which they materially participate:
- If the self-rental produces a net income, the income is non-passive. This destroys the hope of using the rental income to free up suspended passive losses. It also makes this income taxable.
- If the self-rental produces a loss, that loss is passive. Often this suspends the loss and likely adds it to other suspended losses.
As you can see, the self-rental trap gives you the worst of the income and the worst of the loss. Not to worry. We have in our arsenal some tax code exceptions that overcome the draconian rules and enable excellent tax benefits from the self-rental.