How Do I Best Rent My Property to My Business?
Your business is growing and you need more space. The commercial lease prices are insane and you’re wondering if it would be better to just purchase a building than to continue to rent one.
Paying yourself rent is emotionally so much easier than paying the landlord. Choosing this road leads down the path of self-rental.
Purchasing an asset owned individually or in a company (lessor) and leasing it to the operating company you also own (lessee) is known as self-rental. The lessee company is usually an operating company and the lessor is generally a partnership, trust, or individual. This is an extremely common method of managing a business that has many benefits. There are also a few tax nuances you’ll want to keep in mind.
Purchasing real estate in a separate company makes the operating company easier to understand.
Purchasing real estate in a separate company separates the interests of the operating business and the real estate business. This separation draws a clear line between the two businesses. The operating business is focused on serving clients with its own metrics and profitability, while the lessor collects rent.
The primary benefit is simplifying the business. Many large publicly traded companies employ this strategy for this exact reason. Walgreens, Dollar General, FedEx, AMC, Walmart, and many others engage in transactions to separate the buildings from their true business. To understand their business and to limit their capital needs they do not own the real estate in which their stores operate. They sell it to a large real estate company and lease it back (known as a “sale-leaseback”).
It can reduce the risk of your real estate being sold to pay for a lawsuit.
Attorneys generally recommend separate companies for separate assets. One reason for this is to protect from losing assets in one company due to lawsuits in a related company. They talk about a corporate veil surrounding the assets of each company in the event one company is sued. The lessee, or operating company, maintains payroll, equipment, and many of the risks of the business. Placing real estate in a separate company limits the loss to the business if the operating company is sued. The risks with employees, payroll, and equipment in the lessee company are fundamentally different from the nature of the risk of real estate.
For example, if a dispute with a client turns into an argument and lawyers get involved, they may look at the claim, the business insurance, and the potential assets of the business to pay the claim. All assets owned in the operating company may be at risk. The equity of the assets, or the market value of the assets less the debt owed, may be considered to pay the claim and fees. This simple shift to separate assets could save the real estate from being liquidated to pay a claim.
The nature of the income is segmented.
Rent is a passive activity in the eyes of the IRS. Because it is a passive activity, it is not subject to self-employment taxes. A surprisingly forgotten tax, self-employment taxes can increase taxes by 15% of your income. A separate company holding real estate is not subject to self-employment taxes whereas an operating company could be.
In addition, sales involving real estate generally give rise to capital gains. For accountants and analysts, gain or loss from sales is a fundamentally different type of income. It is reported on different tax forms and at various rates. Owning assets in a separate entity limits the gain or loss within the operating company upon selling the property.
Succession plan strategically with real estate.
If you’re building a business for the long term, plan for it to outlive you. When an owner exits and removes him/herself from the operating business, count on touchy conversations with the new owners as they look to make it their own. Owning property outside the operating business can allow the exiting owner a retirement income stream of rents as they “sail into the sunset”.
Be careful with this one.
Make sure there’s more than a handshake or a verbal agreement. Also, make sure the rent is market rate. The new owners may prefer to move the business than renegotiate with an unrealistic landlord.
This can leave someone without the expected income just as they step into retirement.
Strategically retain employees with ownership.
While many employees want to become a partner or shareholder of the operating company, changing ownership isn’t always a preferred option for the existing owners. Offering ownership in assets leased by the business to strategic employees offers them an alternative. Owning a passive investment used by the business can accomplish the objective of communicating their value while keeping the peace at the ownership of the lessee company.
Establish this lease as if it were with a traditional leasing company.
Once you’ve decided to move forward with leasing an asset to your company, treat it like any other lease. Research the market rate. This can be a quick search or a call to a commercial real estate agent. The cost per square foot should be close to the market of your property. After you know the price, sign a lease with language you would use in any other contract.
In the event of an audit, the IRS will question the price you pay. Grossly exaggerating rent prices reduces the profitability of the operating company and may limit your income taxes. An audit will have tests to check for abnormally high rent.
Alternatively, reducing rent below market rate (or even free) could cause the IRS to rule that you/the owners should have received more rent. They can force you to increase the rent to the lessor or adjust your taxes to show you did receive it if you’ve not been charging yourself enough rent. (In this situation, the IRS is ruling the lessor has constructively received this rent and will be taxed on it.) Either situation could have consequences and penalties. Take a minute to research and document your reason for the market rate.
Keep your accounting records separate for the real estate company.
Even if you own the assets individually, this is now a separate business. It creates at least one new schedule in your taxes with its own set of income, depreciation, and expenses. This company has a separate tax identification number (or just the owner’s social security number) and will require a separate accounting file. At a minimum, you will report this activity on your personal return, or you may create another tax return to file.
Self-rental tax laws will ensure your expenses are treated differently than property that is not owned by you.
If you are looking to set your rent to create a loss that you can deduct against the profits of your operating company, the IRS is one step ahead of you. The self-rental rule in the internal revenue code (section 469) states that when you rent property to a business in which you or your spouse materially participate, any rental losses are still considered passive, but the rental income is deemed non-passive.
This interplay between active and passive income and losses can get messy quickly. Know the tax laws are different and a bit more complex. Plan on spending more time with your CPA to work on the nuances of this.
Self-rental is extremely popular because it is so useful.
This strategy is used to build wealth from the business while diversifying (ever so slightly). It can limit liability and retain employees while planning for your succession and taxes. While it does require effort and documentation, it doesn’t require much. Considering the many options provided by self-rental, it is not surprising many business owners choose to go this route.