Business Business Planning

Self-Rental: Charging Yourself Market Value Rent – A Smart Move for Business Owners

Hood & Associates CPAs, PC

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January 16, 2024

Self-Rental: Charging Yourself Market Value Rent – A Smart Move for Business Owners

Many business owners own property and lease that property to the business. These arrangements offer several advantages: you can work out the terms of the lease quickly, and the money changing hands stays with you.

However, one aspect of self-rental that often gets overlooked is the importance of charging your own business fair market value rent. In this article, we’ll explore why charging fair market value rent for your own business isn’t just a formality but a strategic financial move.

Understanding the Basics: The Self-Rental Rule

When you own a property and your business, it’s easy to dismiss the significance of how much rent the business pays for the property. After all, if you own 100% of the business, you’re essentially moving money from one pocket to another. However, this mindset overlooks the self-rental rule.

Internal Revenue Code (IRC) Section 469 prohibits taxpayers from deducting passive activity losses (PALs). A passive activity is any trade or business in which the taxpayer doesn’t materially participate. Rental real estate is generally considered a passive activity regardless of whether the taxpayer materially participates unless they qualify as a real estate professional, which is defined in IRS Publication 925.

Passive activity losses can only be used to offset passive income, although there are a few exceptions.

According to Section 469, when you rent property to a business in which you (or your spouse) materially participate, any net rental losses are still considered passive, but the net rental income is non-passive.

In other words, you can’t offset your net rental income with other passive losses, and your net rental losses can only offset other passive income. Other passive income or losses might come from a limited partnership or other projects that don’t require your active participation.

The self-rental rule can have negative consequences if you hope to offset your self-rental income with passive losses from other activities.

The Self-Rental Rule: An Example

Let’s consider an example to better understand the self-rental rule. Say you own two rental properties: a commercial office building and a warehouse. You rent the commercial office building to a business in which you are the sole owner and rent the warehouse to an unrelated third party.

At the end of the tax year, you have a loss of $20,000 on the warehouse, while the commercial office building has a net income of $50,000. You might think you can offset the income from the commercial office building with the loss on the warehouse, but Section 469 says you can’t.

Because you rented the commercial office building to yourself, the self-rental rules apply, and the income is treated as non-passive. As a result, it can’t be offset with the passive loss from the warehouse.

Now, what happens if the commercial office building self-rental instead generates a loss? In that case, according to Section 469, the loss would be passive. You couldn’t use the loss from either the warehouse or the commercial office building to offset other income, such as profit from the business.

Structuring Self-Rentals

Despite the self-rental rules, there are good reasons—both from a business strategy perspective and a tax perspective—to rent property to your business.
The key is to charge the business fair market value rent. This offers several benefits:

  1. Avoiding non-deductible passive losses. Charging a fair market rent can help you avoid non-deductible passive loss. When the rent is set at the right amount, the rental entity is more likely to generate enough income to cover mortgage interest, real estate taxes, repairs and maintenance, and other costs of maintaining the property.
  2. Cash flow management. Charging market value rent is also a strategic way of managing cash flow. It allows you to extract cash from the business without incurring FICA and Medicare taxes. This is because the rent income reported on Schedule E is not subject to these taxes, unlike salary or business income. It’s a savvy way to reduce your overall tax burden while maintaining compliance.
  3. IRS compliance and audits. The IRS pays close attention to self-rental situations. Charging a rent that’s significantly below market value can raise red flags and potentially trigger an audit. By setting a fair market rent, you align with IRS expectations and reduce the risk of complications during tax audits.
  4. Long-term financial planning. Properly charging rent aids in accurate financial reporting and planning. It reflects the true cost of operations and can influence business decisions, such as expansion, budgeting, and profitability analysis.

 

Best Practices for Setting and Managing Fair Market Rent on a Self-Rental

So how can you figure out how much rent to charge? Here are a few techniques.

  1. Look at comparable rentals. Determine what similar properties in the area are charging for rent. This gives you a baseline for setting your rent.
  2. Consult with a real estate professional. If comparable rentals are not available in your area, a real estate expert can provide insights into current market trends and help you set a competitive rent. Some commercial real estate brokers even post local market reports on their websites, and you can use these reports to calculate the rent per square foot.
  3. Document your decisions. Keep records of how you determined the rent, including market research data and professional advice. This documentation is crucial in case of an IRS audit.
  4. Have a written lease agreement. Have a written agreement between you (or the entity that owns the property) and the business/lessee that establishes the rent and any other expenses the business may pay directly, such as utilities or maintenance fees. This helps the arrangement qualify as an “arm’s-length transaction.”
  5. Make the rent payments regularly. Ensure the business pays its rent regularly, just as if the payments were being made to an unrelated landlord. Actually make the payments—not just accounting adjustments.
  6. Consider local sales tax requirements. Many cities and states collect sales tax on commercial rentals. Be sure to talk to a tax advisor to ensure you collect and remit the proper state and local taxes.
  7. Regularly review and adjust rent. The real estate market is always fluctuating. Regularly review and adjust the rent to ensure it stays aligned with market conditions.

Now that you’re charging fair market value rent, your business deducts the rent expense just as it would payments to another landlord. You, as the property owner, deduct property expenses, such as mortgage interest, property taxes, depreciation, etc. If rental income exceeds your rental expenses, you will have taxable income on your individual income tax return. However, as long as the rental income is from an entity in which you actively participate, it won’t be subject to the additional net investment income tax.

Another word of caution: avoid overcharging rent, as this can also send up a red flag with the IRS. Rental payments that are excessive compared to the market can be reclassified to business income.

Utilizing the Grouping Rules

Under a special grouping rule, you can elect to group your solely owned rental building with your solely owned business and treat the two of them as one activity for the purposes of the passive activity loss rules. For these purposes, 100% ownership can include you and your spouse, if you file a joint return.

For this strategy to work, the rental and the business can be structured as a sole proprietorship, S corporation, or an LLC, but not as a C corporation.

If you elect to group these activities, you can use a loss generated by the rental to offset the net income generated by the business and vice versa.

You must make a formal election on your federal income tax return, and the election statement must identify the names, addresses, and tax identification numbers of the activities that are being grouped.

Get Professional Guidance for Your Self-Rental

Charging yourself market value rent is not just a matter of moving money around; it’s a strategic decision that impacts your financial health and tax situation. By understanding the self-rental rules and properly structuring your transactions, you can avoid potential tax pitfalls, manage cash flow more effectively, and ensure compliance with IRS regulations.

If you need help understanding the tax implications of your self-rental, schedule a free consultation with Hood & Associates. We can analyze your specific circumstances and help you make the best decision for your federal and state income taxes and the success and sustainability of your business.

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