What Are the Tax Implications of Leasing Commercial Property to Your Own Business?
Leasing commercial property to your own business can be a smart financial strategy. It can offer both operational and tax advantages but, it’s important to understand the tax implications involved. To ensure you stay compliant with IRS rules and make the most of the potential benefits, this information is imperative. Keep reading and we’ll explore how leasing your commercial property to your own business affects your taxes and what you should consider when structuring the arrangement.
1. Separation of Entities
To lease property to your own business, you typically need to set up the business and property ownership as separate legal entities. One thing to know is that you should traditionally never hold your real estate and business in the same entity. For example, you might own the property personally or through an LLC while your business operates as a separate corporation or LLC. By keeping these entities distinct, you create a formal landlord-tenant relationship. Doing so allows your business to pay rent and deduct those payments as a business expense.
2. Deducting Rent Payments
When your business leases commercial property from you or a separate entity you own, the rent it pays is generally deductible as a business expense. This can reduce the business’s taxable income, freeing up cash for other operational needs. The key is ensuring that the rent amount is reasonable and in line with market rates. Charging excessive rent can raise red flags with the IRS, potentially leading to audits or the reclassification of rent payments.
3. Rental Income and Expenses
While your business can deduct rent payments, you as the property owner must report rental income on your personal or business tax return. This of course depends on how the property is held. However, you can also deduct various property-related expenses, such as:
- Mortgage interest
- Property taxes
- Insurance premiums
- Repairs and maintenance
- Depreciation
These deductions help reduce the taxable income generated from the rental activity, potentially offsetting a significant portion of the rental income.
4. Depreciation Benefits
As the property owner, you can benefit from depreciation, which allows you to recover the cost of the building (not the land) over time. The IRS permits commercial property to be depreciated over 39 years. This deduction can be substantial and helps reduce the taxable rental income. Even if the property appreciates in value, you can still claim depreciation based on its original cost.
5. Self-Rental Rules
If you lease the property to your own business, you may be subject to the IRS’s self-rental rules. These rules prevent property owners from using losses from renting to their business to offset other non-passive income. In simple terms, while you can deduct expenses associated with the property, you cannot use rental losses to reduce personal or non-passive business income. Any rental income generated is treated as non-passive, and losses are generally considered passive, limiting their deductibility.
6. Qualified Business Income (QBI) Deduction
If you own the property through a pass-through entity (such as an LLC or partnership), you may qualify for the Qualified Business Income (QBI) deduction. This allows eligible owners to deduct up to 20% of their rental income. Certain conditions apply, such as the need to demonstrate that the rental activity is a trade or business, so it’s essential to consult with a tax professional to confirm eligibility.
7. Transfer Pricing Considerations
If your business operates internationally or has foreign entities, transfer pricing rules may apply. These rules ensure that the rent paid between related entities is based on fair market value and is comparable to what independent parties would pay in a similar situation. Transfer pricing regulations help prevent tax avoidance by inflating or underreporting rent.
8. Capital Gains Considerations
If you eventually sell the property, the gain will be subject to capital gains tax. The length of time you’ve held the property and how much it has appreciated will determine the rate at which you’re taxed. Additionally, any depreciation you’ve claimed over the years is subject to depreciation recapture, which is taxed at a higher rate than standard capital gains.
Conclusion
Leasing commercial property to your own business offers potential tax benefits, such as rental income deductions and depreciation. However, it’s important to follow IRS guidelines carefully, ensuring the rent is set at fair market value and understanding the implications of self-rental rules. Working with a tax professional will help you navigate the complexities of this arrangement, maximize your tax benefits, and ensure full compliance with IRS regulations
