In our practice, after we see our clients hit a maturation point in their business, they often start to look for other new and creative ways to build equity. One item that we frequently receive questions on is the opportunity for them to build equity by either buying their building or buying a new building and remodeling it to fit their needs. In this article, we call your attention to the tax implications associated with buying a rental property and specifically, special matters for consideration when the rental agreement is a related party transaction.
Under §162, rent paid on business or investment property is tax deductible as an ordinary and necessary business expense. However, one question clients usually ask is, “how much should I charge?” Like most tax answers, it depends. The tax code does not state that the rent paid must be “reasonable,” as it does for other deductions. However, transactions between “related parties” typically come under closer scrutiny, as there is greater potential for abuse.
If the IRS finds rent paid to a related party to be “unreasonable,” the rental property tax deduction will be reduced, in addition to several potentially unfortunate outcomes:
1. The IRS may recharacterize the rent paid as a gift, or
2. Excessive rent could be recharacterized as a distribution of profits.
When structuring a rental agreement with a related party, you will need to be able to prove that the rent paid is reasonable. We suggest you take specific steps at the inception of your rental arrangement to support the rent you charge.
1. Formal lease. Memorialize your rental agreement in an executed formal written lease. Corporations should also take all formal action related to the transaction. Taxpayers sometimes play fast and loose when the party they are dealing with is related. From a tax standpoint, however, it’s even more important to undertake the proper formalities for related party transactions, in case the IRS seeks to disregard or void the transaction. In several cases, rent paid to a related party has been disallowed because it was not required under a memorialized and executed lease.
2. Establish fair rental value. We recommend you establish the rent is reasonable by showing that it is in line with rent paid by unrelated parties for comparable property. One way to do this is to contact independent real estate professionals, such as realtors or real estate brokers, to get appraisals or advisory on comparable properties.
If the fair value of the rent advised by the real estate professionals is less than what you are or want to charge, you need to carefully document why your specific property should carry a rent premium or higher value. Justification for this may include improvements, special features, build-outs specific to your industry, or prime location. Another way to justify a higher rate of return, is if your particular industry runs at higher rate of return; thus, you are able to charge a premium.
3. Percentage rentals. Occasionally we seek to set the rent amount as a percentage of profit. This is an acceptable method and it can be used to protect against inflation or other risks. However, when this approach is taken, there is a greater possibility that rents will reach an unusually high level, for example during a high-income year, which may be an outlier. To protect against the IRS negating the rent paid in a year such as excessive, it is important to demonstrate that the percentage rental arrangement was reasonable when it was established.
It is also helpful to show that the rent you are charging is aligned with industry standards. Again, it’s important to document independent appraisals to support that the terms of your transaction are market-based when you initiate the arrangement. It is easier to demonstrate that a period’s rental amount is reasonable if you can show that the original rental arrangement was established in a reasonable fashion.
Helping you get there…
Buying a rental property can be an effective method for building equity, but when it involves a related party transaction, the tax considerations can be complicated. Boulay’s tax team is here to assist you in the tax planning and can either prepare or review the formal rental agreement or lease. If you have questions on rental property tax deductions or wish to discuss these matters further, please connect with a member of Boulay’s tax team today.