Tax-Free Income from Rental of Home to Your Business

Read  Augusta Rule: Stay at the Mom and Dad Hotel, where we discuss in depth this little-known escape from taxes.

We don’t specifically discuss renting from your own business in that article, so we’ll discuss it here.

Possible Problem Areas

Having your business rent your home from you for 14 days or less during the year brings up the following seven tax issues:

1. Will the tax law prohibition on deductions for the employee renting to the employer destroy the strategy?
2. Could the entertainment facility rules disallow the entire strategy?
3. Wouldn’t renting to your corporation simply create personal use under the vacation-home rules and thus eliminate the benefits?
4. Would the rule that disallows a tax deduction to a related party when the other related party does not have income from the transaction deny the benefit?
5. Will the “no deduction for personal, family, or living expenses” rule eliminate the deduction?
6. Can the rental pass the ordinary and necessary business expense test?
7. Could the IRS recast this rental as a sham using the substance-over-form doctrine?

Now, let’s see how you overcome each of the seven obstacles that could surface in your business’s rental of your personal home.

 1. Employee Rental to Employer Disallowed Deductions Problem

You are an employer-owner of your business if you are a partnership, S Corporation, or C Corporation. Section 280A(c)(6) disallows rental deductions to the employee who rents his or her home to the employer. This is you, as you are an employee of your corporation, and you are renting to your employer.

No problem. This section causes you no trouble because, under the 14-day free-rent rule, the tax code does not allow you, the homeowner, to claim any tax deductions. (Thus, you claim no deductions for the home under the 14-day rule, and therefore there is nothing to disallow on your personal tax return. And frankly, you don’t care about those deductions anyway—you are looking for the corporate deduction and your receipt of tax-free rental income.)

Here’s a second nail that you can hammer into the employee-deduction-disallowance section of the law: the tax-free-rent section of the tax law overrides the employee-deduction-disallowance section.

2. Entertainment Facilities Problems

Trouble! Yes. Be alert.

Don’t have the business rent your home to entertain patients, prospects, or customers. In general, the entertainment facility rules disallow deductions for a facility used for entertainment, and that disallowance would defeat your rental strategy. So don’t rent the home to your corporation for any entertainment use.

There’s one exception: for the annual employee holiday party or summer picnic, the disallowance of entertainment facilities rules don’t apply. Further, that ugly 50 percent cut that applies to entertainment (including facilities) does not apply to the employee holiday party or summer picnic.

With these rules in mind, limit the rental of your home to your business to business meetings, staff retreats, and employee events, exempt from the entertainment facility rules.

 

3. Related Party Issues(Part 1)

You have no problem with the related-party rules.

First, for purposes of the related-party rules that apply to the 14-days-or-less rental arrangement, you and your family members are related, and the law deems that this family group has an interest in the rental, but your corporation is not included in the group.

Thus, you have no Section 280A related-party problem renting to your business.

4. Related Party Issues(Part 2)

Second, you have no problem with the related-party rule that allows no tax deduction when the recipient-related party does not have to include the income. Why? This rule applies only “by reason of the method of accounting,” and that’s not applicable here.

In this rent-to-your-business strategy, your methods of accounting either are the same (such as the cash method) or, even if different, are not the reason you exclude the income from taxation.

The law allows the nonrecognition of income.

5. Personal, Family, or Living Expenses Disallowance

The tax law has long recognized the use of the personal home for more than one purpose, such as using part of the home for an office or renting part of the home to a third party.

If you clearly show the expense for the rent paid and the business activity that took place, you have no trouble with the personal, family, and living-expense rules.

6. Ordinary and Necessary Business Expenses Definition

The rental of space for business meetings and the annual employee holiday party is without question an ordinary and necessary business expense. Thus, you have a straightforward business purpose for the business’s rent payment.

In Roy, the court noted that the tax-free rule itself contains no requirement that you rent the home at fair rental value for it to be tax-free under the 14-days-or-less rule.

But the IRS privately ruled that the S corporation’s deduction for a rental payment to one of its shareholders can’t exceed the residence’s fair rental value for the activity.

Thus, despite Roy, you should pay a fair rental value (but no more!) and document that the rent is fair. Further, spend a few moments documenting that the business activity took place. Consider taking photos and having them processed so that the date of processing shows on the prints.

7. Substance over Form High-Level View

We don’t see any problem for you on this front if the rent paid is fair rent and the business activities take place.

Your ability to exclude the rent from taxation comes from the law itself, so there’s no argument here. Your business’s ability to deduct the rent it pays for a business meeting and holiday party space is certainly not a substance-over-form issue.

And now you’ve passed all seven obstacles to renting your home tax-free to your S or C corporation.

Takeaways

If you operate your business as anything other than a Sole-Proprietor, the strategy of renting your home to the business for 14 days or less produces a near-perfect tax deduction.

• Your business realizes a $21,000 rental deduction.
• The rental deduction reduces the business’s income, and that reduced income passes through to the business owner on their corporate tax return(1065, 1120S, or 1120).
• The business owner reports the business income (after reduction at the business level for the rent) on his personal Form 1040.
• Because the homeowner rented his home for 14 days or less, he has no taxable income.

To make sure you don’t have trouble:

• Avoid the entertainment facility problems.
• Pay and document a fair rent.
• Document that the business activity took place.

If you have questions about the Rental of Home to your Business, contact me at 509-543-7600 or send a request HERE.

August 2022

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