The COVID-19 pandemic has had a significant impact on the commercial real estate market, leading to erratic price behavior in various markets. The Federal Reserve’s Commercial Real Estate Price Index saw a substantial increase of over 20% in just over a year from the third quarter of 2020 to the fourth quarter of 2021. However, following this surge, commercial real estate prices began to moderate, leading to uncertainty and varied pricing forecasts in the market.
One area of focus that has emerged due to the uncertain commercial real estate landscape is potential tax planning risks and opportunities, particularly concerning the self-rental rules. These rules come into play when a taxpayer owns real estate in a separate entity that is associated with an operating company. For example, a physician may operate a medical practice through one S corporation while owning the building through another S corporation that receives rent from the medical practice. In such cases, any rental income generated by the entity is considered active rather than passive if the taxpayer materially participates in the operating company’s activities.
The self-rental rules reclassify rental income as active income, but any losses produced by the rental activity are still considered passive. This asymmetric treatment can have adverse consequences for taxpayers, as the rental income cannot be used to offset passive losses from other entities. However, there are certain benefits to self-rental income, such as exemption from the net investment income tax (NIIT) and eligibility for the qualified business income (QBI) deduction under specific circumstances.
Tax planning risks associated with the self-rental rules include the potential trapping of passive losses, challenges related to fair rental value determination, and the impact on the QBI deduction. To navigate these risks, taxpayers and tax practitioners must carefully consider the implications of the self-rental rules and plan accordingly.
There are also opportunities for tax planning within the self-rental framework. Taxpayers can leverage the reclassification of rental income as active income to benefit from lower marginal tax rates and deductions. Strategies such as utilizing bonus depreciation, grouping elections, and careful consideration of the overall tax situation can help optimize tax outcomes for self-rental activities.
In conclusion, the self-rental rules present a complex but relevant challenge for taxpayers in the commercial real estate market. By understanding the rules, risks, and opportunities associated with self-rental activities, taxpayers can make informed decisions and maximize tax benefits while avoiding unanticipated results. Careful planning and consideration of the specific circumstances surrounding self-rental arrangements are essential to navigating this complex area of tax law effectively.
