It looks like an elegant arrangement. You own a business, your business needs premises, so you exchange into a building and lease it to your own company. Rent leaves one pocket and arrives in another, and the property is an investment held for productive use.
The structure is legitimate and common. What surprises owners is how the rental income is treated, because a specific rule exists to stop exactly the plan most people have in mind.
What is the self rental rule?
Where you rent property to a business in which you materially participate, net rental income from that property is generally recharacterised as nonpassive.
Net rental losses from the same property generally remain passive.
The rule is deliberately one directional. Income cannot be used to soak up your other passive losses, while losses cannot be used against your active income.
Why does that matter?
Because many owners hold suspended passive losses from other rentals and assume new rental income will absorb them.
Under the self rental rule, income from the building leased to your own business is nonpassive, so it generally cannot be offset by those suspended passive losses. The shelter people expect does not arrive.
Meanwhile, if the self rental produces a loss, that loss is passive and cannot offset your business income.
Does the property still qualify for a 1031 exchange?
Yes. Property held for productive use in a trade or business qualifies, and leasing a building to your own operating company is a business use.
The self rental rule is about the character of the income for passive activity purposes, not about whether the exchange works. The two questions are separate and are sometimes conflated.
What about the net investment income tax?
Where income is nonpassive because of the self rental rule and the activity is a trade or business in which you materially participate, it may fall outside the 3.8 percent net investment income tax. The analysis depends on the facts and on how activities are grouped.
That can be a genuine advantage, which is worth weighing against the loss of passive income to shelter other losses.
Can grouping help?
Sometimes. In certain circumstances a rental activity can be grouped with the operating business it serves, where the ownership and other conditions are met. Grouping affects material participation, the passive characterisation and the treatment on disposition.
Grouping elections are technical, have long term consequences, and are difficult to change. They should be considered with a CPA before an exchange rather than after.
What should the lease look like?
Whatever the tax characterisation, the arrangement should be a real lease on commercial terms:
- ›Written lease with a defined term
- ›Rent at market rate, supported by comparables
- ›Rent actually paid on schedule
- ›Normal landlord and tenant obligations
- ›Consistent reporting on both sets of returns
Below market rent creates its own problems. Above market rent can be recharacterised. Both invite scrutiny.
What happens when the business is sold or closes?
This is the risk that gets overlooked. A building leased to your own company depends on that company. If the business closes, relocates or is sold, you own a property whose only tenant has gone.
Before exchanging into a building for your own business, ask what the property is worth to an unrelated tenant. Single purpose buildings can be difficult to re let.
Is it still a good idea?
Often, yes. Owning your premises builds equity instead of paying rent to a landlord, gives control over the space, and provides an asset that can be sold or exchanged later independently of the business.
The point is to plan it with the income characterisation understood, rather than discovering it when suspended losses fail to release.
What to do first
Before exchanging into a property your own business will occupy, ask your CPA three questions: how the rental income will be characterised, whether any grouping election is in place or advisable, and what happens to your suspended passive losses under the arrangement. Then have the lease drafted on commercial terms before the first rent payment.
Nothing here is tax, legal or investment advice. Passive activity and grouping rules are technical. Confirm your position with your CPA.
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This article is educational and not tax, legal, or investment advice. 1031 exchanges are complex — consult your own CPA and attorney. DST and fund offerings are securities available to accredited investors only; all examples are illustrative.