If you rent property to a business you materially participate in, the net rental income from that property is treated as nonpassive. A net loss from the same property stays passive. That one-way rule is in Treas. Reg. §1.469-2(f)(6), and it surprises a lot of owners. The profitable building cannot soak up passive losses from your other rentals. And a loss on the building, say after a cost segregation study, cannot offset the income of the business that pays the rent.

This page is part of our REPS and passive losses series. If passive losses are new to you, start with why you cannot deduct rental losses against W-2 income.

When the rule applies

Two facts trigger it. You rent an item of property to a trade or business. And you materially participate in that business for the year under any of the seven tests in Temp. Reg. §1.469-5T(a). The classic case is a dentist, a contractor, or a manufacturer who owns the building in one LLC and runs the business in another entity that pays rent.

The type of tenant entity does not change the answer. The regulation covers any trade or business you materially participate in, whether you run it as a sole proprietorship, an S corporation, a partnership, or a C corporation. The Tax Court applied it to S corporation tenants in the Carlos case below. The Ninth Circuit, which covers California, applied it in Beecher v. Commissioner, 481 F.3d 717 (9th Cir. 2007). The owners rented a home office to corporations they worked in full time. The court held the rent was nonpassive and could not be sheltered by losses from their five other rentals. The court also said the rule applies without any showing of a tax-avoidance motive.

Married couples who file jointly are treated as one taxpayer for these rules. If one spouse owns the building and the other runs the business, the rule can still apply. The grouping regulation uses that exact fact pattern in its first example.

The only carve-out in the regulations is narrow. Rent under a written binding contract signed before February 19, 1988 is excluded under Treas. Reg. §1.469-11(c)(1)(ii). Almost no lease in place today fits.

It works property by property

The rule looks at each item of property, not the whole rental activity. In Carlos v. Commissioner, 123 T.C. 275 (2004), the owners rented two buildings to two of their own companies and treated the two rentals as one activity. One building made money. The other lost money because the tenant stopped paying rent. The Tax Court held the income from the first building was nonpassive and the loss from the second stayed passive. Grouping the two rentals together did not let them net.

A simple illustration

This is hypothetical arithmetic, not a client result. You own your practice's building and charge your S corporation fair market rent. After expenses and depreciation, the building nets $40,000. You also own two rental houses that lose a combined $30,000.

Without the self-rental rule, the $40,000 would absorb the $30,000 and you would pay tax on $10,000 of net rental income. With the rule, the $40,000 is nonpassive and fully taxable. The $30,000 becomes a suspended passive loss that carries forward on Form 8582.

Now flip it. You run a cost segregation study on the building and take bonus depreciation, and the building shows a $150,000 loss for the year. That loss stays passive. It does not offset the S corporation's profit, even though the S corporation paid the rent. For how bonus depreciation and loss limits stack, see REPS, cost segregation, and the 2026 excess business loss cap.

Fix one: group the building with the business

Treas. Reg. §1.469-4(d)(1) lets you group a rental with a trade or business only if the two form an appropriate economic unit and one of these is true:

  • The rental is insubstantial compared with the business.
  • The business is insubstantial compared with the rental.
  • Each owner of the business has the same proportionate ownership in the rental. In that case, only the part of the rental used by the business can be grouped.

The ownership test is the one that usually works. You own 100% of both, or you and a partner own both 50/50. Two people who own the building 50/50 and the company 70/30 usually do not pass it.

When the grouping holds, the building's rent and expenses become part of the business activity. If you materially participate in the business, both income and losses from that part of the building are nonpassive. A cost segregation loss can then offset business income, subject to basis, at-risk, and the excess business loss cap.

Three cautions before you group:

  • Disclosure. Rev. Proc. 2010-13 requires a written statement with the original return for the year you first group activities. If you skip it, each activity is generally treated as separate. Late relief exists in limited cases.
  • It sticks. Under §1.469-4(e), once you group activities you cannot regroup in later years unless the original grouping was clearly inappropriate or a material change makes it clearly inappropriate.
  • C corporations are different. An activity you conduct through a C corporation can be grouped with your other activities only for purposes of testing material participation, under §1.469-4(d)(5)(ii). If your business is a C corporation, talk through the limits before relying on grouping.

Fix two: real estate professional status

If you qualify as a real estate professional under §469(c)(7) and materially participate in your rentals, your rentals are not passive. A loss on the building can then be deductible against other income, again subject to basis, at-risk, and the excess business loss cap. If you also make the §1.469-9(g) grouping election, all your rental real estate is one activity for material participation.

The catch is the hours. Time in your dental practice or your manufacturing company is not time in a real property trade or business. Most owner-operators of non-real-estate businesses cannot pass the more-than-half test. See what counts toward real estate professional hours and material participation vs active participation.

The 3.8% NIIT side

Rent that is nonpassive because of the self-rental rule, or because you grouped the rental with your business under §1.469-4(d)(1), is treated as earned in the ordinary course of a trade or business under Treas. Reg. §1.1411-4(g)(6). In practice, that generally keeps the net rent out of the 3.8% net investment income tax. Gain on selling that property can get the same treatment under the same rule. For the broader rules, see REPS and the 3.8% NIIT.

The QBI side

For the 20% qualified business income deduction, a rental that would not be a trade or business on its own is treated as one if you rent it to a business under common control. That is Treas. Reg. §1.199A-1(b)(14). Common control generally means the same person or group owns 50% or more of both.

There is a second edge. If the tenant is a specified service business, such as a medical, dental, law, or accounting practice, and there is 50% or more common ownership, the rental to that practice is treated as part of the service business under §1.199A-5(c)(2). Above the income thresholds, that can shrink or eliminate the deduction on the rent. California does not allow the federal QBI deduction at all.

California

California follows the federal passive activity rules except for REPS. For California, all rentals are passive, so a REPS-based fix does not carry over to the state return. FTB's Form 3801 instructions say California generally conforms to Rev. Proc. 2010-13 on grouping disclosure and does not require a separate state statement. Expect the federal and California numbers to differ when REPS is part of the plan. See California REPS and FTB Form 3801.

Common mistakes

  • Counting on the building's profit to absorb losses from other rentals.
  • Running cost segregation on an owner-occupied building without checking whether the loss will be passive.
  • Assuming a C corporation tenant avoids the rule.
  • Grouping on paper without the Rev. Proc. 2010-13 statement.
  • Charging rent with no market support. Keep comparables in the file.

Frequently asked questions

What is the self-rental rule?

Under Treas. Reg. §1.469-2(f)(6), net rental income from property you rent to a trade or business you materially participate in is treated as nonpassive. A net loss from that property stays passive.

Does the self-rental rule apply if my business is an S corporation or C corporation?

Yes. The regulation covers any trade or business you materially participate in. The Tax Court applied it to S corporation tenants in Carlos v. Commissioner, 123 T.C. 275 (2004), and the Ninth Circuit applied it to C corporation tenants in Beecher v. Commissioner, 481 F.3d 717 (2007).

Can self-rental income offset my other passive rental losses?

No. Because the net income is nonpassive, it cannot absorb passive losses from your other rentals. Those losses carry forward on Form 8582.

Can a grouping election fix the self-rental problem?

Often, if the building and the business form an appropriate economic unit and you meet one of the §1.469-4(d)(1) tests, usually identical proportionate ownership. Then income and losses from the grouped part of the building follow your participation in the business. You must disclose the grouping under Rev. Proc. 2010-13, and it is generally binding in later years.

Does real estate professional status get around the self-rental rule?

It can make a loss on the building deductible if you qualify and materially participate in the rental. Hours in a non-real-estate business do not count toward REPS, so many business owners cannot qualify.

Is self-rental income subject to the 3.8% net investment income tax?

Generally no. Treas. Reg. §1.1411-4(g)(6) treats rent recharacterized as nonpassive under the self-rental rule, or through a §1.469-4(d)(1) grouping, as earned in the ordinary course of a trade or business.

Talk it through with us

Bring the lease, the entity ownership for the building and the business, last year's Form 8582, and any grouping statement already on file. If you are planning a cost segregation study on a building your business occupies, bring that too. We will show you whether the income and losses land as passive or nonpassive before you file. Book a complimentary consultation.

LaviCPA is a Los Angeles CPA firm for real estate investors. Shawn Lavi, CPA, is the firm's principal. Elias Lavi, CPA, is its founder and co-owner.