By Kevin Kennedy, Esq.
Whether you’re a retailer, a broker, a doctor, etc., you know that renting commercial office/retail space can be your most expensive operating cost. You also know that one of the ways to build wealth is to invest in real estate. For these reasons, you might decide to purchase the building/space you’re currently renting. If you decide to go down that path, consider the following:
- Setup a separate legal entity. Generally, you do not want the same company runs your business to hold/own the real estate. Here’s a simple example to illustrate:
Insurance Broker runs his practice via his S-Corporation, Broker, Inc. Broker, Inc. rents an office from Landlord. Broker works out a deal to purchase the building from Landlord. Rather than Broker, Inc. buying and owning the building/real estate from Landlord, Broker would set up a separate company, likely an LLC, to buy and own the office space/real estate. Why? For asset protection. More on that below. In the example above, we’ll refer to Broker, Inc. as the “Operating Entity” and the LLC that owns the real estate/medical suite as the “Asset Entity”.
- Enter into a Lease Agreement. Enter into a lease agreement between your Operating Entity and Your Asset Entity, and have the Operating Entity pay rent to the Asset Entity. By having the two entities enter into a lease agreement with each other, it reinforces the notion that, legally, these are two separate entities. The reason this is important is that if Operating Entity is sued, the asset/real estate is safely owned by the Asset Entity, outside of the lawsuit. Aside from reinforcing the asset protection, you want the Operating Entity to have an expense it can deduct, i.e. the rent amount. It should be somewhere in the range of what rent is for that market, etc.
- Follow the Self-Rental Rule. Internal Revenue Code (IRC) section 469 governs the ability of a taxpayer to use passive losses against ordinary income. Generally, passive losses can only offset passive income. Generally, rent received by a Landlord is considered passive income. As a result, there is an incentive to characterize or increase passive income to be offset by passive losses. However, under IRC 482, and the ‘self-rental rule’ found in the Treasury Regulations and applicable tax court case law (Williams, Castro, etc.), when the tenant is an affiliated entity of the landlord and the landlord materially participates in the operations of the tenant-business, the rent received by the landlord (in this case the Asset Entity) is generally not considered passive income. As a result, you can’t artificially re-characterize the ordinary income received by the Operating Entity into passive income when you own both the Operating Entity and the Asset Entity.
For example:
Broker has not yet purchased the building and pays rent to the Landlord. Broker, Inc. has a net annual income of $225,000 (before paying rent). Broker, Inc. pays rent of $60,000 annually to the Landlord. Broker, Inc. deducts that $60,000 as an expense. Broker has $60,000 of passive losses from other passive investments. Broker has no passive income, and therefore, cannot use or ‘harvest’ those passive losses against its ordinary income. Instead, Broker must carryforward those passive losses to next year.
Alternatively, Broker could set up an LLC and use the LLC to buy the building from the Landlord. Broker, Inc. pays $60,000 annually to the LLC. Broker, Inc. deducts the $60,000 as an expense. The LLC receives $60,000 annually as passive income. Except for the self-rental rule, the $60,000 passive losses could be used to offset the $60,000 of rent income/passive income. However, due to the self-rental rule, the $60,000 of rent income is not considered passive income, and the Broker cannot use or ‘harvest’ those passive losses but must carry forward those passives to next year. Further, the self-rental rule also requires that if the Asset Entity had losses, e.g. $60,000 of gross income and $80,000 of expenses such as depreciation, etc., the $20,000 loss is considered passive and could not be used to offset the ordinary income of Broker, Inc.
What’s the Takeaway?
Despite the self-rental rule, the outcome of all of this is positive: #1 Broker owns a valuable asset and #2 Broker indirectly retains the $60,000 rent expense. Remember, the purpose here is to provide asset protection; it’s not necessarily a tax strategy.
In sum, it is wealth-building 101 to become both a real estate investor and a business owner. Just make sure to operate those activities in separate companies, and remember, the notion of paying yourself rent is primarily for asset protection/building wealth, not necessarily to save on taxes. If you have any questions, please contact our office.