A taxpayer cannot rent property to him or herself. This is similar to the concept that a taxpayer cannot pay themselves a salary.
For example, if a taxpayer has a sole proprietorship and he or she reports the income and expenses of that business on Schedule C of Form 1040, the taxpayer is not able to deduct salary expense on the Schedule C for “wages” paid to him or herself. This makes sense because a taxpayer cannot enter into a contract with him or herself. If you cannot contract with yourself to pay yourself a salary, how could you receive a salary from yourself?
This, of course, would be different if the taxpayer operated his or her business through a partnership or a corporation. Partnerships and corporations are separate legal entities.
In Cox v. Commr., 121 F.3d 390 (8th Cir. 1997), the IRS disallowed the Schedule C rental expense of a sole proprietor attorney. The Tax Court allowed half of the rental because it was only half owned by the attorney --- the other half was owned by his wife.
The issue in the case was whether Mr. Cox was entitled to deduct payments made to his wife and on behalf of his law practice, for the rental of property owned by Mr. and Mrs. Cox as tenants by the entireties. Mr. Cox’s law practice occupied and paid “rent” of $18,000 to Mr. & Mrs. Cox for the property during 1987. On their joint 1987 Federal income tax return, Mr. & Mrs. Cox reported receipt of the $18,000 in rental income on their Schedule E. Mr. Cox reported the $18,000 in rental payments on his Schedule C for his law practice as an ordinary and necessary business expense.
The IRS disallowed the Schedule C rental expense of $18,000 in its entirety because the payments were made for the use of property to which Mr. Cox had title and in which he held an equity interest. The IRS also deleted the corresponding rental income reported by Mr. & Mrs. Cox on Schedule E. Contrary to the positions argued by both parties , the Tax Court held, and the 8th Circuit affirmed, that based on Mr. & Mrs. Cox’s interest in the property, as determined by Missouri law and under Code §162(a), Mr. Cox was entitled to deduct one-half of the payments, and, in turn, one-half of the payments were reportable as rental income on the joint return.
Essentially, the Tax Court said that the half of the property owned by Mr. Cox could not be rented to himself. On the other hand, the portion of the real estate owned by Mrs. Cox could be rented to Mr. Cox (via his sole proprietorship).
This principle also makes sense where the taxpayer wholly owns an entity that is disregarded for U.S. tax purposes (a “disregarded entity”). Under state law, the entity is a separate legal entity. As a separate legal entity, it can enter into contracts, including contracts with its owner. However, for Federal income tax purposes, the entity is generally disregarded. As a disregarded entity, transactions between the owner and the entity are generally disregarded. Thus, if the disregarded entity were to contract with the owner to pay rent to the owner, the rent would be disregarded, just as the entity is disregarded.
Note that the above discussion is entirely separate from the “self-rental” rule in Treas. Reg. §1.469-2(f)(6). The rule in the Code §469 regulations determines whether rental income is passive or non-passive. The discussion above addresses whether the taxpayer has rental income or expense at all. If the taxpayer does not have rental income or rental expense because he or she is renting to him or herself, you would never even get to the self-rental rule in the Code §469 regulations. That is, if you don’t have rental income, there is no need to determine if the income is passive or non-passive.
Below is a chart depicting the situation in the Cox case.