How to Turn Self-Rental Losses into Tax Savings

What is a Self-Rental?

When business owners buy or build a property for their business, they often set up a separate entity (usually an LLC) to own the building and land. When the owner’s business rents the building from the LLC, then it establishes what’s known as a “self-rental” agreement. This structure protects them from liability but can create tricky tax problems if not planned carefully.

How Self-Rentals are Treated

If your operating business leases a building from your real estate LLC, that’s considered a “self-rental” and are subject to the rules under Code Section 469. Normally, rental income is considered passive, but if you actively participate in the operating business then the rental income from the property is considered active income. On the other hand, any losses from the real estate LLC are treated as passive.

That mismatch means:

• Losses from the real estate LLC can’t reduce your business income.
• Rental income from the LLC can’t be offset by passive losses from other rental properties.

Here’s an Example Without Planning:

A doctor owns a medical practice (an S-Corp) that makes $750k in taxable income. The doctor builds a $5M office building (with $2M in land value) held in a separate LLC. The real estate LLC shows a $50k loss.

Because of the self-rental rules, that $50k loss can’t offset the $750k business income. The loss gets carried forward until the doctor has passive income or sells the property. Taxable income stays at $750k.

How to Avoid the Trap: Grouping Election

Business owners can avoid this problem by using a grouping election under §1.469-4(d). This lets the real estate LLC and the operating business be treated as one activity for tax purposes.

Benefits:

1. Converts passive real estate losses into nonpassive losses.
2. Allows those losses to offset active business income.

To qualify, the activities must be considered one “economic unit.” Factors include:

• Similarities and differences in type of trades or businesses
• The extent of common control
• The extent of common ownership
• Geographical location
• Interdependence among the activities

Example with Grouping Election:

Same doctor, same practice ($750k income), same $5M building. But this time:

• The doctor elects to group the entities.
• A cost segregation study generates an $850k loss on the property.

Now:

1. The doctor can offset the $750k business income with the $850k real estate loss.
2. Taxable income drops to $0.
3. An extra $100k loss carries forward to next year.

Important Considerations

• Election must be filed with the first tax return (Rev. Proc. 2010-13).
• Once made, it generally must stay consistent unless:
  • It is determined that a grouping election was clearly inappropriate
  • A material change in facts and circumstances warrants a grouping change
  • The IRS finds that a grouping of activities does not represent an appropriate economic unit and a principal purpose of the grouping is to circumvent the underlying purposes of Code Section 469

If you Don’t Elect to Group

Grouping may not be helpful if you already have passive income to offset the real estate losses. Grouping can also reduce exposure to the Net Investment Income Tax since the rental income becomes nonpassive.

Conclusions:

Self-rental setups can save business owners big on taxes—but only if handled correctly. The rules are complex, so it’s essential to work with a tax professional to see whether a grouping election or other strategies make sense for your situation.