Leasing or renting The difference between renting and leasing is the length of time covered in the agreement. Leases tend to be for longer periods of time, generally lasting for a year or more. property to your own business is an innovative way to create a business deduction while retaining and building real estate equity. When you own the building, you can manage the equity and take advantage of depreciation deductions on your personal tax return.
If you lease or rent property to your partnership, S Corporation (S-corp), C Corporation (C-corp), or multi-member LLC (MMLLC), special self-rental rules apply. Conversely, the IRS completely ignores any lease or rental agreement between you and your sole proprietorship (SP) or single-member LLC (SMLLC) treated as an SP.
Key Takeaways
- The primary advantage of renting or leasing property to your business is to avoid transferring property in and out of the business, which can result in recognized gains and losses.
- The rental income passed out of the business is not subject to payroll tax like owner salaries.
- The self-rental rules treat rental income as nonpassive and rental losses as passive.
- Shareholders in S and C corporations can obtain income from self-rentals without payroll tax.
Choose your entity type from our drop-down menu to go directly to that section of this guide to see whether renting or leasing property to your own company is possible.
Can I Lease or Rent My Commercial Building to My Sole Proprietorship?
No, you cannot. The IRS does not permit a sole proprietor to take a deduction on Schedule C for rental expense and report that same movement of cash as income on Schedule E.
The IRS has indicated that an ordinary and necessary business expense can only be taken for rent on property in which the taxpayer does not have equity or hold title. The IRS does not want taxpayers reallocating income and expenses merely to obtain a tax advantage.
If you own the building as a sole proprietor, you can still use it for your business activities—you just can’t personally recognize rental income from the business, and the business can’t take a deduction for the rental expense.
Click here for a sample scenario.
Let’s assume that a taxpayer sells clothing but needs to find a building to use for a storefront. If the taxpayer happens to own a suitable piece of property but is established as an SP, they may not deduct rent paid from the clothing business to themselves.
They may not report this deduction because the IRS does not distinguish between the two parties involved in the transaction and views this arrangement merely as a strategic movement of cash from one pocket to another. However, the SP could deduct any mortgage interest, utilities, or other building expenses they pay as the owner of the building.
Can I Rent or Lease a Commercial Building I Own to My Single-member LLC?
Legally, yes, you may be able to enter a lease contract with your SMLLC depending on the laws of your state. However, if the LLC activity is reported on Schedule C of your tax return, you can’t deduct the rent expense.
The flip side is that you also won’t report the rental income on Schedule E. However, if your LLC elects to be treated as a corporation, you can deduct the rent expense and show the rent income on Schedule E.
An LLC is organized under state law where it is recognized as a separate legal entity. However, an SMLLC that doesn’t elect to be treated as a corporation isn’t recognized by the IRS. This LLC is referenced as a disregarded entity. This means that for tax purposes, the IRS treats transactions between a taxpayer’s SMLLC and the taxpayer the same way it would with an SP.
Both the Schedule E rental income and the Schedule C rental expense deduction are disallowed. As noted with SPs, you can still use the commercial building for SMLLC business purposes; however, you wouldn’t recognize rental income, and the business can’t recognize rental expense.
Can I Lease or Rent a Commercial Building to My Multi-member LLC?
Similar to the rental arrangement between you and your partnership, the IRS allows you to lease or rent your commercial building to an MMLLC where you are a member. Again, self-rental rules would apply. Net rental profit would be reported as nonpassive, whereas a net rental loss would be reported as passive.
If the entity has elected to be treated as an S-corp or a C-corp, the tax treatment for the elected entity type would apply.
Can I Rent or Lease a Commercial Building to My Partnership?
Yes. However, as a member of the partnership renting the property, you are subject to self-rental rules. The partnership would take a deduction for the rental expense.
As the individual landlord, you would report nonpassive rental income if the net expenses and income resulted in a profit and a passive loss if the net income and expenses resulted in a net loss.
A big benefit of drawing rental income out of your partnership is that the rental income is not subject to self-employment tax like general partnership income. However, the rent charged must be fair market value, so the IRS does not recharacterize the rent as a guaranteed payment.
Can I Lease or Rent a Commercial Building I Own to My C Corporation?
As with the previous entities, a rental arrangement is permitted since both you and the company are distinctly separate for tax purposes. There are two main benefits to renting commercial property to your C-corp.
1. Offers compensation flexibility: In general, C-corp shareholders can only withdraw cash through dividends and wages. When your corporation pays rental income to you personally, you now have a third option for cash flow.
Under the third option, you can save on the payroll taxes that would be allocated to wages by taking rental income instead. Rent is also preferred to dividends because C-corps can deduct rental expenses, whereas they cannot deduct dividends paid to shareholders.
2. Helps you avoid the tax traps of corporate real estate ownership: Renting property to a C-corp where you are a shareholder allows the entity to have access to closely held real estate without having to place the property into the corporation.
Down the road, if property held in the corporation is sold for a gain, it would be taxed initially on the corporate return and then again on the individual shareholder’s return when the funds are distributed. This creates an extremely unfavorable situation, which can be avoided by the corporation renting instead of owning.
Can I Rent or Lease My Commercial Building to My S Corporation?
Yes. Since you and your S-corp are separate legal entities, you are permitted to rent property you own to your business.
Much like the C-corp arrangement, renting property from you keeps the property out of the corporation, saving the trouble of having to distribute it (or the resulting gain/loss on sale) upon disposition of the property or dissolution of the corporation. As with C-corps, you can save on payroll taxes by taking more compensation in rental income and less in wages.
You are still required to pay yourself a reasonable salary as an S-corp shareholder. Also, you are allowed to take cash distributions from an S-corp, but rental income allows for another option for cash flow as part of your total strategy.
Self-rental Rules
A self-rental transaction occurs when the lessee and lessor are essentially the same person. When an individual rents property to any other standard pass-through entity or C-corp, the IRS’s self-rental rules must be considered.
- Rental income paid to taxpayers who materially participate in a company’s business activities is considered nonpassive.
- Rental losses for taxpayers who materially participate in a company’s business activities are considered passive.
As a general rule, the IRS does not allow passive losses to offset nonpassive income. For most business operations, the IRS considers the income from your activity to be nonpassive if you materially participate in the business operations. Meanwhile, rental income from outside sources is generally considered passive for most taxpayers who aren’t real estate professionals.
Self-rental rules can’t be avoided with a management company. Historically, taxpayers have attempted to circumvent the self-rental rules by setting up a separate entity to collect the rent from the commercial property, even if that entity is an S-corp. The tax court has ruled that the property owner is the final taxpayer and self-rental rules still apply. Self-rental rules also still apply to C-corps.
Click here to see a sample scenario.
Let’s assume that you own a barbershop organized as an S-corp and are the only barber in the establishment. By being the only staff member, you would be responsible for all of the business decisions and operations, so the bar for material participation would be cleared fairly easily. Your barbershop income is nonpassive.
If you own the building in which the barber services take place and rent that building to your S-corp, the rent paid from your S-corp to you would also have nonpassive income, due to the self-rental rules.
Suspension of Passive Losses
If your rental income and rental expenses combined create a net loss, that net loss would be considered passive and would be carried over until you have passive income from this or another activity to absorb the loss.
When Self-rental Passive Losses Are Unsuspended
Thankfully, a prior year passive loss from a self-rental activity can be used to offset current year nonpassive self-rental income when the loss and income being combined are for the same self-rental activity. Were it not for this arbitrary exception to the general rule, self-rental losses could only be absorbed by investments in other passive activities.
Self-rental Rules & the 199A (QBID)
The qualified business income deduction allows noncorporate taxpayers who meet certain criteria to deduct up to 20% of QBI. In most cases, passive rental income would not be considered for QBI. However, the IRS has indicated that self-rental activities qualify for QBI if they meet specific IRS rules on common ownership.
Self-rental Rules & Non-Real Estate Property
Self-rental rules are often only considered in the context of real estate. However, these rules also apply to equipment and other kinds of property that might be rented or leased to the business. This is an important consideration when laying out your overall business strategy.
Advantages & Disadvantages of Leasing or Renting Commercial Property to Your Company
How to Lease or Rent Property to Your Business
There are three major steps to consider when leasing or renting property to your own business:
Step 1: Determine Fair Market Value for Rent
Pinpointing how much rent to charge your business can be done by looking into what other landlords are charging for similar spaces. This analysis will help you defend yourself against any future IRS challenge to your business strategy.
The IRS has internal valuation guides and valuation engineers who determine the value of property and the fairness of rates charged by taxpayers in related party transactions.
So, if the IRS thinks that the rent you are charging your business is too high, then it may believe you are abusing the rental process and trying to avoid paying the appropriate amount of tax. As such, it could reclassify some or all of the rental payments as salary or dividends for corporate entities.
Step 2: Identify Local Requirements for Commercial Rental
Some cities and states require special business licenses for commercial landlords. Ensure that your business activity meets the appropriate zoning requirements for the location.
Step 3: Prepare a Formal Leasing or Rental Agreement
Your lease or rental agreement should be structured the same way that an external party would structure the agreement. All relevant details regarding responsibility for utilities, maintenance, and any shared spaces should be included. The agreement should also include the duration of the contract and renewal terms.
Frequently Asked Questions (FAQs)
LLCs offer the easiest and most flexible option for ownership of rental properties.
The Augusta rule is a way for taxpayers to rent their homes tax-free for up to 14 days out of every year. The name is derived from the city of Augusta, GA, where this rule was created to shield rental income for residents who rented out their homes tax-free during the Masters Tournament. This is also a popular strategy in college towns with popular football programs.
The self-rental rules classify rental income as nonpassive and rental losses as passive. These rules apply when a taxpayer rents property to an LLC, partnership, corporation, or other business entity that they control.
Bottom Line
If your business is organized as an SP or an SMLLC, rental activity between the business and the owner is ignored. The business and owner are a single taxable entity, and renting property is like taking money out of one pocket and placing it in the other—there’s no taxable event.
If you are an owner in a partnership, corporation, or MMLLC, the income and deductions can be reported, but the self-rental rules apply. These rules generally result in rental income being characterized as nonpassive and rental losses being considered passive.
