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February 18, 2015

2015 Tax Considerations: Self-Rental Income Part 1

The Net Investment Income (NII) tax went into effect in 2013, but if you participate in a self-rental property arrangement, now may be a good time to review your tax filings and entity structuring as we head into filing season. The NII Final Regulations included a reversal from a position taken in the 2012 Proposed Regulations concerning the treatment of self-rental income.

As a reminder, the 3.8% Medicare surtax on qualifying NII includes three buckets:

  1. Gross income from interest, dividends, annuities, royalties and rents, unless derived in a trade or business in which the taxpayer materially participates
  2. Gross income from a trade or business that is a passive activity or the trade or business of trading in financial instruments or commodities
  3. Net gain from the disposition of property, other than property the income generated from which otherwise would be excluded under Bucket 1 or 2

For a detailed description of the NII tax, feel free to read our previous post on the topic.

In this example, Bob is an attorney and operates his law practice in which he materially participates inside an S-Corporation of which he owns 100% of the stock. Bob also owns the property in which the law practice operates inside of a separate single-member LLC. Under the terms of the lease, Bob’s law practice pays rent to the single-member LLC.

In most circumstances, rental income is by nature considered passive income. However under Reg. §1.469-2(f)(6), rental income derived from property rented to a trade or business in which the taxpayer martially participates “is treated as not from a passive activity.” In the example presented above, since the rental income in Bob’s single member LLC is derived from the S-Corp, which is an operating business in which Bob materially participates, the income would be considered nonpassive. Also, Bob may group the rental activity with the operating business activity under Reg. §1.469-4(d)(1) thus making the grouped activity a nonpassive activity.

Initially under the Proposed NII Regs, self-rental income appeared to be subject to the 3.8% because it fell within the “rents” description in Bucket 1, unless the rental income was proved to be “derived in the ordinary course of a trade or business.” After hearing complaints from tax professionals, Treasury reversed the position in the Final NII Regs allowing rental income from a self-rental to be excluded from Bucket 1 if it is treated as a nonpassive activity (Reg. §1.469-2(f)(6)) or if the rental activity is grouped with an active trade or business activity (Reg. §1.469-4(d)(1) ) (and the grouped activity is nonpassive to the taxpayer).

For most small business owners, it’s common to split real estate and active business operations into separate legal entities for liability issues. Therefore, it is critical that taxpayer’s develop an understanding of self-rental structuring. A rental lease’s arrangement could change the nature of a property owner’s involvement in the trade or business such as in the case of an Operating lease versus a Triple-net lease. This arrangement is one example of a tax planning opportunity available for self-rental property owners.

Also, how you deal with the disposition of the activity or property can affect if your operations are viewed as a trade or business or an investment property. Read more about these considerations in Part 2 of our blog post series.

If you have any further questions regarding the NII tax or your self-rental property, please feel free to contact Bryan Koch at bkoch@cbiz.com or 901.685.5575.


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