Tax Treatment for Self-Rented Property Under the Passive Activity Rules

Like many tax laws, there are exceptions to the passive activity rules.  Rental income or loss is generally a passive activity whether or not the taxpayer materially participates in the rental operations. 

An exception to this rule applies to self-rental property.  Self-rental property is property owned by an individual, which is rented to an entity in which the individual materially participates.  If this is the case, the rental income is recharacterized as nonpassive income under IRC Sec. 469(I)(3) Reg. 1.469-2(f).  Rental losses remain passive.

Determination. To determine if this rule applies, you must first determine if you meet the material participation test. If any of the following tests are met, the taxpayer is deemed to materially participate in the activity.

  1. The taxpayer participates in an activity for more than 500 hours during the tax year.
  2. The taxpayer’s participation in the activity for the current year constitutes substantially all the participation of all individuals in the activity, including non-owners.
  3. The taxpayer participates in an activity for more than 100 hours during the tax year, and no other individual, including non-owners, participates more hours than the taxpayer.
  4. The activity is a “significant participation activity,” and the taxpayer’s total participation in all significant participation activities exceeds 500 hours. A significant participation activity is one in which (a) the taxpayer cannot be treated as materially participating under any of the other six tests, and (b) the taxpayer participates in the activity for more than 100 but fewer than 500 hours.
  5. The taxpayer materially participates in an activity for any five of the ten immediately preceding tax years.
  6. The taxpayer materially participates in a personal service activity for any three preceding tax years (consecutive or not).
  7. The individual participates on a regular, continuous, and substantial basis.

It is important to note, when applying the material participation rules, that participation by a taxpayer’s spouse is considered participation by the taxpayer regardless of whether the spouse has an ownership interest.

Why did the IRS enact this code?  The income recharacterization rules prevent a taxpayer from creating passive income to offset other passive losses.  Without these rules, a taxpayer with suspended passive loss carryover could inflate the gross rent of self-rented property as a strategy to create passive income.

Is this subject to the 3.8% net investment income tax?  No. In situations in which self-rental income is treated as nonpassive, the rental income is deemed to be derived in the ordinary course of business and therefore, exempt from the net investment income tax.