BUSINESS DEVELOPMENTS
Self-Rental Issues

By David A. Anderson, CPA
Margolis & Company, P.C.

It is common for small business owners to own business real estate personally and lease it to the operating entity that conducts the business activity (i.e., to their S corporation or LLC). This arrangement has several advantages, including creating a rental income stream that is free of payroll taxes and protecting the real estate from the liability risks associated with the business, but the tax rules contain a trap for the unwary if the rental arrangement runs in the red in the owner’s Form 1040.

The “self-rental” regulations of the IRS take the position that rental losses from these self-rental arrangements must be suspended as passive losses and cannot be used currently in the real estate owner’s tax return, even if there are other self-rentals that produce positive income. This IRS interpretation was recently approved in a major Tax Court decision, where a small business owner was not permitted to offset rental income from one building against the rental loss from another building. Both buildings were leased to businesses in which the owner or his spouse were actively involved.

There are several defensive strategies that can prevent this trap. First and foremost, make sure that, as a real estate owner leasing property to your own business, the rent is always paid! If cash flow gets a bit tight in the business, be sure that your own rent gets paid and, if possible, that the self-rental remains in positive territory. If your business entity runs in the red, those losses are generally fully allowable because of your personal participation in the business. But a self-rental loss is automatically suspended as a passive loss and must be deferred until passive income is created or the property is disposed of.

In those cases where payment of reasonable rents does not allow the rental arrangement to achieve positive net income in your Form 1040, such as may occur with fresh depreciation or significant interest expense on building debt, there is an elective tax strategy that we can consider. It is possible to group a self-rental property with the business in order to overcome the passive loss status of the rental arrangement. This grouping can be accomplished if the rental property and the business have identical ownership. Alternatively, grouping can occur if the rental activity is insubstantial in comparison to the business activity.

Gulf Opportunity Zone Incentives

At the end of December, Congress enacted new legislation to incent businesses to make investments in the Hurricane Katrina core disaster area. Businesses that need to restore damaged property in those areas along the Gulf damaged by Katrina, or businesses that may be considering expansion into those counties or parishes, will find significant depreciation incentives. Investments in either tangible personalty or real estate, whether new or used, qualify for a 50% first-year depreciation write-off. These rules apply through 2007 in the case of tangible personalty, and through 2008 for buildings and other real estate improvements. This first-year write-off is particularly significant with respect to buildings, as commercial real estate is subject to a 39-year depreciable life.

In addition, the first-year Section 179 deduction for equipment and other tangible personalty purchases is expanded by $100,000 for investments in the Katrina core disaster area through 2007. Thus, the normal Section 179 limit for 2006 of $108,000 becomes $208,000 in that zone.

New Production Deduction

For businesses, the major new tax development for 2005 is a tax deduction for those that manufacture, produce, grow, or extract tangible personal property or construct real estate within the U.S. This deduction starts modestly at 3% of the net income from qualified production, but increases gradually until reaching 9% by 2010.

Eligible Income

Manufacturing, construction, farming, and mining activities qualify, but service businesses (other than engineering and architectural services related to real estate construction) and retail and wholesale activities do not qualify. This new deduction will be relatively straightforward for businesses that only engage in qualifying production because the computation is based on overall net income. However, businesses engaged in a combination of eligible and ineligible activities (e.g., a manufacturer that also purchases finished products that it merely distributes, or an electrical subcontractor that does both qualifying construction and non-qualifying repair services) will need to determine the net income attributable only to the qualifying production in order to claim the new deduction.

Fortunately, there is a 5% de minimus rule that allows us to ignore disqualifying service revenue or distribution revenue from wholesaling the products of another business, if the gross receipts from the disqualifying activity are under 5% of total sales. For businesses that have over 5% of their gross from non-production activities, however, it will be necessary to segregate the net income for purposes of calculating the new production deduction

Real Estate Developers

Another area of complexity occurs with real estate developers. When each lot or property is sold, the gain attributable to infrastructure improvements is considered qualifying construction income, while the gain attributable to appreciation in the land value is ineligible. This rule suggests a nightmarish gain allocation process for each property development sale, but, thankfully, a safe harbor mechanism has been added to IRS proposed regulations. This elective rule allows a taxpayer to treat all development gains as qualifying for the new production deduction, assuming an adjustment is made to the land cost to account for assumed appreciation. Under this safe harbor, if the land has been held zero through five years, the land cost is increased 5% in calculating the net qualifying production income. If the land was held six through 10 years, 10% is added, and for land held 11 through 15 years, 15% is added. For land held over 15 years, this safe harbor approach is not permitted, and detailed allocations must occur.

For more information about these or any other topics, please feel free to contact a Tax Specialist at Margolis & Company P.C.:

Jeffrey S. Winkleman, CPA
jwinkleman@marg.com

Stephen A. Bleyer, CPA
sbleyer@marg.com

 John E., McGary, PCA 
jmcgary@marg.com 

Daniel L. Effron, CPA
deffron@marg.com