Self-Rental Rules: When Rent From Your Own Business Isn't Passive

Rental activity is passive by default under IRC Section 469. The self-rental rule carves out one situation: you rent an item of property for use in a trade or business activity in which you materially participate for the year. When that happens, an amount equal to the net rental activity income from the property is treated as not from a passive activity.

Three conditions do the work:

• You rent the property to a business. Typical cases are a building leased to your medical or dental practice, your S corporation, your partnership, or your own sole proprietorship.
• You materially participate in that business. The tests are the seven in Treas. Reg. 1.469-5T. A physician working full time in the practice almost always meets them.
• The year shows net income from the property. The rule only applies to income. A net loss is not recharacterized.

IRS Publication 925 adds that the rule does not apply to net income from property rented under a written binding contract entered into before February 19, 1988, and it does not apply to property covered by the separate rule for rentals incidental to development.

The IRS designed the rule so owners could not pay themselves rent from a business to manufacture passive income and free up passive losses from other investments. The side effect is the trap in the next section.

A cost segregation study moves part of a building's cost out of 39-year property into 5, 7 and 15-year classes. For qualifying property acquired after January 19, 2025, those shorter-life components can be eligible for 100% bonus depreciation. On an owner-occupied building that usually turns the first year into a large rental loss.

Now apply the self-rental rule. The business deducts the full rent against its nonpassive income. The building reports a loss, and because the rule only recharacterizes income, the loss stays passive. Without passive income elsewhere, it is suspended.

What happens to it later? The regulation measures net rental activity income after passive deductions for the year, including deductions carried into the year from earlier years, to the extent they are reasonably allocable to the property's income (Treas. Reg. 1.469-2(f)(9)(iv)). So the building's later profits can absorb part of its own carryforward over time. What the carryforward cannot do on its own is offset your wages or practice profit. The rest waits for other passive income or a sale of the building in a fully taxable transaction to an unrelated party under IRC Section 469(g).

This is not a reason to skip cost segregation on an owner-occupied building. It is a reason to decide the structure first. Our property-type guides for medical offices and other commercial buildings walk through the study side.

A hypothetical dentist (married filing jointly, household income well above $150,000, so the $25,000 rental allowance is gone) owns 100% of her practice S corporation and 100% of an LLC that owns the building. The LLC leases the building to the practice at a market rent of $120,000 a year. The building basis, excluding land, is $1,500,000. Interest, property tax, insurance and repairs run $80,000. A cost segregation study reclassifies 25% of the basis into property eligible for 100% bonus depreciation. Round, illustrative numbers; no real client.

Without the study the building nets a small profit, which is nonpassive under the self-rental rule. With the study, the building shows a $363,846 loss. What happens next depends on one decision made in advance:

• Not grouped. The loss is passive. With no other passive income, all $363,846 is suspended. The practice still deducted the $120,000 of rent against its income, so her total tax picture looks like the study never happened this year.
• Grouped with the practice. She owns the same percentage of both, so the ownership test in Treas. Reg. 1.469-4(d)(1)(i)(C) is met, and the building and practice can form an appropriate economic unit. The building is part of the practice activity, in which she materially participates. The loss is generally nonpassive and can offset practice and other income, subject to basis, at-risk and excess business loss limits. At a 35% federal bracket, using $363,846 this year instead of years from now is worth roughly $127,000 of federal tax timing in the first year. That is a timing benefit; depreciation taken now is subject to recapture rules at sale.

Run your own numbers below.

When you sell, depreciation recapture comes back into play. Our depreciation recapture guide shows how the accelerated components and the building itself are taxed at sale.

A rental activity can be grouped with a trade or business only if the two form an appropriate economic unit and one of three tests is met:

1. The rental is insubstantial in relation to the business.
2. The business is insubstantial in relation to the rental.
3. Each owner of the business has the same proportionate ownership interest in the rental. In that case the part of the rental that involves property rented for use in the business can be grouped with it.

The third test is the one most owner-users use. A sole owner of both the practice and the building meets it easily. Two partners who own the practice 50/50 and the building 50/50 meet it too. Partners who own the practice 60/40 and the building 50/50 do not, and the insubstantial tests rarely help with a building large enough to justify a study.

The appropriate economic unit question looks at the facts and circumstances, including similarities between the activities, common control, common ownership, geographic location, and how the activities depend on each other. A building used by the business it is grouped with is the classic case.

What grouping costs you

• It is close to permanent. Under Treas. Reg. 1.469-4(e), you may not regroup in later years unless the original grouping was clearly inappropriate or a material change in facts makes it clearly inappropriate.
• It must be disclosed. IRS Publication 925 requires a written statement with your original return for the year you first group activities, add an activity to a group, or regroup. If you fail to disclose, each activity is treated as separate. Late disclosure can still count as timely if every affected return was filed consistently with the grouping and you disclose in the year you discover the failure.
• A building sale alone may not free losses. Suspended losses release under IRC 469(g) when you dispose of your entire interest in the activity. Once the building and practice are one activity, selling only the building is not a sale of the whole activity.
• It does nothing in a profit year. If the building shows net income, the self-rental rule already makes it nonpassive. Grouping matters for loss years, which is why it belongs in the plan before the study.

The same rule that frustrates the loss year often helps in the profit years.

Two limits are worth knowing. The QBI rule covers rentals to a business conducted by you or by a partnership or S corporation; a building leased to your C corporation does not get that treatment. The NIIT exclusion assumes the business itself is not a passive or trading business described in Treas. Reg. 1.1411-5. If you are a passive investor in the tenant business, the self-rental rule does not apply in the first place. Our QBI deduction guide for real estate covers the rest of the Section 199A rules.

The business deducts rent as an ordinary and necessary expense under IRC 162(a)(3). Because you sit on both sides of the lease, the number has to stand up on its own:

• Charge market rent. Keep a short file showing comparable rents per square foot in your area, refreshed when the lease renews.
• Sign a written lease. Term, rent, escalations, who pays taxes, insurance and repairs (triple net or gross), and who owns improvements.
• Pay it like rent. Monthly transfers from the business account to the building LLC account, booked as rent on both sets of books.
• Plan for the exit. A buyer of your practice will want a lease on market terms, and the building may outlive your ownership of the business.

For the business side of the entry, our guide to deducting business rent covers how the expense is reported.

Most owner-users hold the building outside the operating business. The tax reasons:

• Getting it out of a corporation later is expensive. A corporation that distributes appreciated property recognizes gain as if it sold the property (IRC 311(b)), and that rule reaches S corporations through IRC 1371(a). A building held in a separate LLC can stay with you when you sell the practice.
• Rent is not payroll. Rent paid to your LLC is not subject to self-employment tax, and it is not wages from your S corporation.
• The exit stays flexible. You can sell the practice and keep collecting rent from the buyer, sell the building separately, or sell both.

Liability protection is another common reason for a separate LLC; that part is a question for your attorney. The full buy vs. lease decision, including when owning does not make sense, is in our guide on whether your business should own its building.