A common source of investment income is owning rental properties. Rental properties can be tax advantageous in that, after considering depreciation, the property can have positive cash flow with little to no taxable profit. Rental activities can also be tax beneficial because they are by definition "passive", and their losses in most cases can be used to offset other passive income. This can be very helpful for taxpayers subject to the Net Investment Income Tax (NIIT), also known as the 3.8% Medicare surtax because passive income is considered Net Investment Income (NII).
But, there is a situation where this is not applicable which involves "self-rental" activities. A taxpayer is engaged in self-rental when a property is rented for use in a trade or business activity in which the taxpayer materially participates. For example, a taxpayer owns a building personally. The taxpayer rents that building to their business, a corporation, in which they are a majority stockholder and work full time. This would be characterized as a self-rental activity because the taxpayer is renting the building to a business in which they materially participate.
Self-rental activities are treated differently than normal rental activities when it comes to passive activity losses. By rule, income generated from self-rental activities is treated as nonpassive, but losses are treated as passive. The treatment of income or loss from the self-rental activities can have a significant impact on the taxpayer's tax situation as a whole. If the taxpayer has a $1,000 income from a self-rental activity, and a $1,000 loss from a normal rental activity, those two activities do not "offset" under the passive income rules as they would if both activities were normal rentals. The impact is instead of having a net $0 rental income on their tax return, the taxpayer ends up with a $1,000 net rental income and a $1,000 passive activity loss, which will most likely be suspended until future years when the taxpayer has other passive income.
This is a big point of contention for taxpayers engaged in rental activities, because tax law defines all rental activities as passive no matter what, then in the fine print excepts self-rental activities. The rule also unjustly penalizes taxpayers that, for tax or estate planning purposes, want to keep real estate assets from their businesses. The business can be sold, merged, or closed but the taxpayer will always own the building.
This has been a rule for many years, however has resurfaced under new scrutiny in 2013 in conjunction with the NIIT. By treating income from self-rental activities as passive instead of nonpassive, a taxpayer can mistakenly reduce their NII subject to the NIIT and also their taxable income as a whole. When a taxpayer reduces their NII by passive losses, they should be prepared to justify how they are treating their rental activities in the event that the IRS inquires as to whether the activity is self-rental or normal rental. Taxpayers should also reevaluate their rental arrangements between themselves, businesses they work in, or other partnerships where they have ownership interest to ensure they are in compliance with the self-rental rules.