The Benefits of Self-Renting
Tax advantages of self-renting
If you’ve spoken to an attorney about owning your practice’s building, chances are they’ve advised the title to be held within a separate entity for asset protection purposes, specifically an LLC. And while there aren’t many one size fits all answers in the world of taxes, owning real estate in an LLC vs any type of corporation is really as close as it gets. That because when real-estate owned in a corporation is repurposed to a different legal entity or passed on in a transfer of estate assets, it creates unfavorable tax ramifications. Most of our readers should be purchasing real estate in an LLC separate from their practice which is most likely a corporation, or at least electing to be taxed as a corporation. This does however, create a tax dilemma.
Passive vs. Active Income
To complicate matters, the IRS considers rental properties as a passive activity and stipulates that passive losses cannot be deducted against non-passive (active) income sources. Non-passive income includes W-2 wages, 1099 income, and net income from your practice. That’s important because by owning your practice’s building you won’t have any outside tenants paying you rent. And without rental income your deductions for mortgage interest, depreciation, and otherwise deductible overhead expenses will create a passive loss which cannot be deducted against your non-passive income sources. Unless you have an outside portfolio of real estate investments yielding your passive income, how can you take advantage of these deductions/losses?
Be your own landlord: self-rent
By having your practice (tenant) pay your building (land lord) a monthly rent, which will be considered income to the building and an expense to the practice, you will be able to deduct the operating expenses of the building to the extent your building claims income (rent). For example let’s say you had the following circumstances:
Practice Income: $100k
Expenses in building (interest, property taxes, utilities, etc.): -$20k
Well if your practice generates income of $100k and your building has costs of $20k, you won’t be able to deduct the expenses of the building since they’ve generated a passive loss and you’d be stuck paying taxes on the full $100k in practice income. Now let’s say your practice pays your building annual rent of $20k. Well now your practice is only claiming income of $80k and your building now has $20k in rental income to offset those expenses. Now you’re only paying taxes on the $80k left in the practice.
What should my practice pay my building in rent?
The IRS requires a “fair market value” rental rate be charged on self-rentals whereas your ideal tax situation occurs when your rental rate is at least high enough to cover the deductible expenses of the building. There are no bullet-proof calculations for this but we find that a rent rate of between 8-12% of the total building value generally does the trick. The taxpayer can also benefit from a higher rent since a higher rent results in lower income in the practice allowing you to justify a lower W-2 compensation. This would reduce FICA taxes and likely the reason the IRS specifically stipulates rent to be fair market. As a rule of thumb, if your rent is only modestly above your deductible operating expenses on the building and is similar to other similar rental properties in your market, it should be of no cause for concern.
For our particularly savvy readers out there thinking about jacking up their rent to create passive income in the building to offset outside passive losses, not so fast. The IRS has created a special treatment here where yes, self-renting losses are passive, however, any profits are considered non-passive income. This therefore prohibits you from generating net rental income to offset your outside passive losses. As a supplemental prize here though, since this income is non-passive you don’t get hit with the 3.8% Net Investment Income (NII) tax assessed on rentals and other passive income activities.
Talk to your CPA
Aside from the tax advantages of owning your practice’s building, it also provides some marked advantages for building wealth and gives you flexibility when planning for the transfer of estate assets. As with any investment decision, purchasing your building needs to be considered in the global context of your financial situation. If you have questions about your existing building or the pros and cons of buying vs renting, give one of our CFO Advisors a call today!