Many business owners often operate their businesses using real estate which they also own. While this can be a great strategy to create wealth for the business owner, it also exposes them to liability: legal issues with the operating business could expose the real estate to legal claims and vice versa. One typical solution separates the legal ownership of the real estate from the business. The business then leases the real estate from the newly created legal entity.
What type of legal entity should business owners choose?
It depends. There are many different options available when selecting the type of legal entity to hold real estate. While every situation is unique, many owners are frequently advised to setup a limited liability company or LLC. This is generally the most “user friendly” choice and often gives the owner the most flexibility both legally and for tax purposes.
Sometimes owners are advised to setup corporations to hold real estate for liability protection purposes. Although this could be very sound legal advice, holding real estate in a corporation can have very significant tax implications including: double taxation and no favorable capital gains rate if taxed as a C corporation, distributions of appreciated real estate may trigger taxable gain, and basis issues with S corporations may limit tax losses and could cause the distribution of debt proceeds from a future refinance to be taxable.
Business owners should seek out advice of attorneys and tax advisors to ensure the entity they select fits the owner’s legal and tax goals.
The IRS trap for the unwary: Self-Rental Rules
In basic terms, the IRS puts business owners into one of two buckets: active or passive. While there are many specific requirements, an active owner typically looks like an individual involved in the day-to-day management of the business. Unless an exception exists, the IRS puts everything else (including rental income activities) into the passive bucket. This distinction is important since tax losses from passive activities are limited to the extent of passive income each year – in other words, passive losses cannot be used to reduce other items of income such as wages, interest, dividends, etc.
The legal separation of real estate from the business is considered a “self-rental” by the IRS and, assuming an owner is considered active in their operating business, is an exception from the general passive classification of rental income. This means that income from a self-rental cannot be offset with passive losses of other activities as would typically be available if this rental were not considered a self-rental.
The self-rental booby trap is triggered when the rental property results in a tax loss for a given year. This loss is subject to the passive activity loss rules and could be disallowed (assuming no other passive income) even if the operating business has taxable income in the same year. These disallowed losses are carried forward and would be available to offset future passive activity income. While income generated by a self-rental activity is considered active, prior disallowed losses of a self-rental can be used to offset future taxable income of such self-rental.
The rules related to self-rentals are very dependent on the “facts and circumstances” of each situation and can cause surprising results at tax time. If you currently use this legal structure (or plan to in the future) and have questions about the tax implications, please contact us for further assistance.