Do you own the real estate for your restaurant, bar, or nightclub? If so, you probably keep it in a separate LLC and file a separate tax return. If not, please check out The Ideal Tax Structure for Your Restaurant’s Real Estate to understand the ideal tax structure for your real estate. Renting your real estate to a restaurant, bar, or nightclub which you own and materially participate in is known as a self-rental. A self-rental can have devastating tax consequences if not planned and structured appropriately.
In this article, we’ll outline the self-rental traps and tax planning opportunities that you need to be aware of if you own the real estate for your bar, restaurant, or nightclub.
The Self-Rental Tax Traps
Real estate income and losses are generally (unless you are a real estate professional) considered passive and can only offset other sources of passive income and losses. Passive income is income from an activity that you do not materially participate in, such as interest income, dividend income, and other investment income. Nonpassive income is income that you materially participate in, such as a restaurant or restaurant group that you run and manage.
The self-rental trap is that you cannot offset passive losses from your restaurant’s real estate property with nonpassive income from the restaurant. For example, assume your restaurant’s real estate generates a loss of $50k after receiving rent from the restaurant and paying its taxes, insurance, repairs, and interest, and the restaurant generates a $50k profit. You will get taxed on the $50k profit, and the $50k real estate loss will be suspended unless you have sources of other rental or passive income that can offset the loss.
The tax law was designed this way so that you don’t put real estate for a business in which you actively participate into a separate entity; rent it out for above-market rent so that you can create passive income to offset your unused passive losses from other unrelated activities. With the proper planning, this trap can be circumvented.
Grouping Your Self Rental With Your Operating Entity
You can circumvent the loss limitation mentioned above if you actively operate your restaurant, bar, or nightclub by making an election on your personal tax returns to group your real estate activity with your operating entity. This election will allow you to net the income and losses from your operating and real estate entities without limitations.
However, this election can be problematic if you decide to sell your operating entity and retain your real estate entity because your real estate entity must retain the nonpassive classification for a minimum amount of time (5 years). There are certain criteria that must be met to qualify for grouping the operating and rental activities, therefore we recommend you consult your tax advisor.
Adjusting Income and Expenses of Your Self-Rental
Another option would be to adjust the rental arrangement so that it has the desired outcome. The desired outcome depends on whether you have other sources of passive income. If you do not have other sources of passive income, the desired outcome is a break-even or slightly profitable self-rental, so the rental losses are not classified as suspended passive losses. If you have other sources of passive income that you can offset using the passive rental losses, the desired outcome is a self-rental that generates a loss.
You can adjust the income of the real estate entity by either (1) moving fixed assets/expenses related to the property from the operating entity to the real estate entity or (2) adjusting the rent charged by the self-rental. You must ensure that the rent amount is relatively market value and reasonable (although this has proved to be a rather flexible rule based on past tax court cases related to the matter).
The Self-Rental Tax Benefits
Typically, rental [passive] income is subject to the net investment income tax (NIIT) of 3.8% if your adjusted gross income is above a certain threshold ($250,000 for married filing joint; $200,00 if filing single for 2024). However, since the self-rental rules classify rental income as non-passive, they are not subject to the NIIT. This is another reason that creating a slightly profitable rental arrangement for the real estate as mentioned in the previous paragraph will not have detrimental effects.
Also, the qualified business income deduction (QBID) discussed in The Best Tax Classification For Your Restaurant is typically unavailable for rental real estate. However, a self-rental can be grouped with its operating entity, as discussed above, to take advantage of this deduction. Consult your tax advisor for more information on how to do this.
Finally, a self-rental scenario can be highly beneficial without any adjustments if you have a lot of other passive income. When the self-rental generates losses, they will be considered passive losses and can be used to offset passive income. When the self-rental generates income, it will be considered non-passive and not subject to the NIIT. This is a win-win situation for taxpayers with other sources of passive income. Unfortunately, many restaurateurs don’t have much passive income, so this situation rarely applies. If the owners of the real estate have passive income, then it could be beneficial to create a scenario where the rental real estate generates losses. Again, you must ensure that the rent is relatively market value and reasonable.
Conclusion
We hope this article has helped you navigate the tax traps and planning opportunities available to restaurants, bars, and nightclubs that own the real estate from which they operate. Analyzing the rental agreement between your real estate and your restaurant, bar, or nightclub is part of our standard onboarding process for clients.
Feel free to contact us to learn more about how The Fork CPAs can help you strategically set up the accounting and taxes for your restaurant, bar, and nightclub.
