Self Rental Guide

From Bob Jennings at TaxSpeaker. Check out TaxSpeaker at taxspeaker.com

One of the single best tax planning tools is the self-rental income tool. When an individual owns an operating business many unplanned for tax situations can occur such as self-employment tax, the .9% Medicare surtax, and the 3.8% net investment income tax, Properly treated in a legal business-like manner, self-rental income can avoid all 3 of these additional taxes, but it must be crystal-clear in legality, operation, business purpose, and business-like treatment. I will provide that guidance below, using a simple example to illustrate. 

Jessica and Mirco own a small real estate brokerage office operating as an LLC taxed as an S corporation, with one additional employee. They also own their 3,000 square foot office building in Naples Florida that is located on a very visible street. They currently run all building expenses, including depreciation, utilities, taxes, insurance, mortgage interest and repairs through their LLC realty firm. Because the real estate business has annual ups and downs, they have kept their salaries very low, removing all profits as distributions, but are in an extreme audit risk area for unreasonably low salaries. Let’s say the annual expenses are as follows: 

Depreciation                $30,000

Utilities                           25,000

Taxes                            25,000

Insurance                      15,000

Mortgage interest        20,000

Repairs                         10,000

Total                           $125,000 

Before the building expenses and officer wages their annual net income is $425,000. Their income is lowered by $125,000 by these expenses, but they are only drawing $50,000 apiece in salaries while drawing the remaining $100,000 apiece in distributions, which are well into major concern areas for unreasonably low compensation. Let’s see what we can do. 

Step 1: Establish a new LLC, owned in the same percentage as the brokerage. Then transfer the building and assign the mortgage (with bank approval) to the new LLC. Let’s call the new LLC “RE LLC”. Transferring the building to the LLC is a non-taxable transaction (assuming debt does not exceed basis), so depreciation and mortgage interest will now be deducted at the same amount by the LLC. I know, you are saying this doesn’t save a dime in tax! I agree, but what it does do is legally protect the building (and vice versa) from the liabilities of the other activity, while also providing us with a mechanism for tax savings. The building must be in a separate legal entity for this to work. 

Step 2: Go to the website www.loopnet.com and search for office space in Naples, FL of a comparable size and location. Print the results to a PDF in the new LLC’s permanent file and you have now established, without argument, fair market value rental. Let’s say FMV rental of a comparable size and location is $30 per square foot, or $90,000 annually. What most people do not realize is that commercial leases are almost always called “triple-net”, which means the tenant pays all costs of occupancy. 

Step 3: Draw up a standard commercial triple net lease between the S Corp LLC and the RE LLC, where rent is $90,000 annually, but the S Corp pays all of the other $75,000 of expenses. This means that the RE LLC will have $90,000 of rent income and $50,000 of expenses, netting a $40,000 profit. The S Corp deducts the remaining $75,000 of expenses, plus $90,000 of rent, resulting in a $40,000 additional deduction. 

This ends up with no net tax income tax effect, but reduces “reasonable compensation” exposure by that same $40,000. So the S Corp, before expenses still starts with $425,000 of income, but now it subtracts $165,000 of building expenses, $100,000 of officer salaries and shows $160,000 of profit instead of $200,000 as before. The LLC shows $40,000 income (90-25-25). The biggest savings however is when the operating business is a sole proprietor or an entity taxed as a partnership, because it also has a direct tax savings for self employment tax purposes on $40,000 (or $6,000!), plus liability protection. 

What are the other benefits? 

1. Self-rental income is exempt from self-employment tax;

   
   

2. Self-rental income is that rare active income exempt from SE tax (on a separate not self-rental activities should never show a loss because it is passive);

   
   

3. Self-rental income is currently exempt from both the .9% Medicare tax and the 3.8% Net Investment Income tax; (Reg 1.1411-4(g)(6)

   
   

4. The sale of an actively operated asset (the self-rental building) is also exempt from the NII surtax for active owners (if the owners sell the business but retain the building, it keeps this character for 10 more years under IRC 469!);

   
   

5. Self rental income qualifies for the 20% QBI deduction under Reg. 1.199A-4(b)(14).