You own the building. Your business rents it from you. One hand pays the other, everybody’s happy, taxes stay in the family. Sounds like a win-win, right?

Except the IRS has a name for this setup and it has a tax rule that’s not on your side.

Let’s talk about self-rentals, including what they are, why they sometimes backfire, and what you can actually do about it.

What Counts as a Self-Rental?

A self-rental happens when you own a property (personally, or through an entity) and rent it to a business you materially participate in. “Materially participate” is IRS-speak for actually running things in the business on a regular basis, not just cashing checks from a distance like a silent partner.

For example, say you own a building through an LLC and your separate S corp runs the actual business out of that building and pays your LLC rent.

There’s nothing shady here. This is a common setup for small businesses, and for good reason. It offers asset protection and estate-planning advantages, and it keeps the real estate separate if you ever sell the operating business. The structure isn’t the problem.

The tax treatment is.

The Trap: Heads the IRS Wins, Tails You Lose

Normally, rental income is passive. You can only offset passive income with passive losses from things like other rental properties or a business or investment in which you don’t materially participate. That’s the whole appeal of rental real estate for many investors.

Self-rentals don’t get that treatment.

Under the self-rental recharacterization rule (Reg. §1.469-2(f)(6), for those who like citations!), if you rent property to a business you materially participate in, any net income from that rental gets recharacterized as non-passive. This sounds harmless until you realize it means you can’t use that income to soak up passive losses from your other rental properties anymore. It’s treated as active income, full stop.

But what really stings is if the self-rental generates a net loss instead, that loss stays passive.

Yep, income is nonpassive so it can’t shelter your other passive losses. Losses are passive so they can’t offset your other active income.

It’s a lose-lose; you get punished both ways. There’s no version of this where the IRS lets you have it both ways. The rule exists specifically to stop people from having it both ways. Womp womp.

So when your self-rental throws off a loss (which happens a lot because of depreciation), that loss doesn’t just sit there waiting patiently. It gets suspended and carries forward. And it stays stuck until you have passive income to absorb it, or until you dispose of the activity entirely (i.e., sell the building). A lot of property owners plan to hold on to that piece of real estate for decades and maybe even pass it to their kids. Which means those losses could be locked up indefinitely.

Not ideal.

The Fix: Stop Letting Depreciation Pile Up on the Wrong Side

You have two levers here. Use them before the losses accumulate, not after.

1. The grouping election

This is the big one. If your rental activity and your operating business meet certain ownership and structural tests, you can elect to group them together as a single activity for passive loss purposes. Once grouped, the loss from the rental side can offset income from the operating side, because as far as the IRS is concerned, it’s all one activity now.

This isn’t automatic, and it isn’t something to DIY off a blog post (even this one). Grouping elections need documentation, consistency year over year, and a genuine economic relationship between the entities. Get it wrong, or leave it undocumented, and you’re inviting exactly the kind of IRS scrutiny you were trying to avoid.

2. Leasehold improvements vs. building improvements (who pays matters)

There’s another strategy many property owners aren’t aware of until it’s too late. When you build out or renovate the space, who owns the improvement determines who gets stuck with the depreciation.

If your rental entity (the landlord side) pays for and owns the improvement, it’s a building improvement. You capitalize and depreciate it on the landlord’s books. That’s the passive side (aka the side we’re trying to avoid), so any resulting loss gets trapped right where you don’t want it.

But if your operating business (the tenant side) pays for and owns the improvement instead, it’s a leasehold improvement, sitting on the operating business’s books. That’s the active side (the good side!). The depreciation deduction lives with your material-participation business, where you can use those losses to offset active income instead of seeing them get quarantined. 

Long story short, you have the same buildout and spend the same dollars, but there’s a completely different tax outcome, depending on which entity writes the check and holds title to the improvement. These tweaks are why it’s so important to work with a tax professional on planning and strategy. 

This approach won’t fix everything. Big-ticket items like a new roof, HVAC replacement, or structural work often make more economic sense sitting with the landlord regardless of the tax wrinkle. But for a lot of the improvements small business owners make, including build-outs, fixtures, and tenant-specific renovations, deciding in advance who pays and who owns it is a lever you can pull. Most people just aren’t aware of it.

Plan Now, or Regret Suspended Losses Later

Self-rentals aren’t a mistake. They’re a completely normal and even smart way to structure real estate and operations. But the passive loss rules will happily let your depreciation losses sit in tax purgatory for years if you let them.

But we can’t stress enough that these fixes require planning before the losses pile up, not after. Once you’re three years into suspended losses on a building you have no intention of selling, your options shrink fast.

If you’ve got real estate and an operating business under the same roof (literally), it’s worth a conversation about how you structure those entities and how you pay for improvements before your next renovation, not after. Reach out to Countless. That’s exactly the kind of strategic tax planning conversation we love having with clients.