Here is a scenario to consider: You do your mechanical work on your truck in the shed on your property and would like to rent the shop space to your company.

Can you rent this shed to your trucking business?  How would that be done on your tax return? Be careful, as self-rental can be expensive if you do it wrong.

Let’s begin with the strategy of renting your shed to your trucking business.

The goal is to deduct rent paid as an expense for your trucking business and appear as rental income on Schedule E of your tax return.  Potential benefits include:

  • No self-employment tax on the full amount of rent paid.
  • Depreciation and interest deductions lower your taxable income.
  • The rental income qualifies for the 20% Qualified Business Deduction in most cases.

Sounds incredible, right?

Hold on. Internal Revenue Code 469 messes up our plan by reclassifying self-rental income as non-passive, but losses remain passive.  “Passive” and “non-passive” doesn’t mix well since, on Schedule E, you can only deduct passive losses from passive income.  This is what happens:

  • Rental income higher than your local market can be re-characterized as dividend distribution income.  Hint: Document how you arrived at your rent price based on the going rate in your area!
  • Net losses from other passive activities cannot offset self-rental income.
  • S-Corporations paying rent to the owner(s) is also self-rental, including home offices.

It gets scarier!

Internal Revenue Code 162(a)(3) states rental expenses are only allowed as a business expense IF THE TAXPAYER DOESN’T OWN THE PROPERTY.  The tax court case in this link shows the IRS removing the self-rental deductions from your business, handing the taxpayer a large tax bill for the extra income.  Ugh.

Tax court cases are revealing because they show us how to avoid making expensive mistakes on tax returns. The tax court case analysis above shows us state law can be used to determine property rights.  That taxpayer lived in Missouri and was married, but his spouse wasn’t involved in his business.  Therefore, based on Missouri laws, she owned half of the rented property and was able to claim half of the rental income.  His company was able to deduct that same amount.

The scary part of that case is this guy’s office wasn’t part of his home or even on his residential property.  It was an office building big enough to rent to other businesses in addition to his law firm.  Yikes!

Here’s a solution (warning: it’s a pain in the neck):

  1. Form a two-member LLC owned by yourself and spouse.  A single-member LLC may not survive an examination, so if you’re single, think about who you’d trust to be a partner and legally own half of it.
  2. Open a bank account for the new LLC since your trucking business will be writing checks to the LLC.
  3. Transfer the property title to your new LLC.  Talk to your insurance agent to see if the LLC needs to have a separate policy.
  4. If the property has a mortgage, transfer it to the LLC.
  5. Write and sign a formal “triple net” lease between your trucking company and the new LLC.  Triple net leases charge your trucking company for rent, utilities, insurance, real estate taxes, and maintenance expenses associated with the building.
  6. Research the highest fair market value for this type of rent (think mechanic shops in this case).  Print and save your research with the lease agreement.  You can use a site like Loop Net to do the research.

The IRS will have a hard time re-characterizing this as a self-rental. Still, there will be a lot of work regarding an updated mortgage, property insurance, potential zoning issues, and the additional expense of a partnership tax return.

Setting up a rental agreement with your company brings a lot of risks. Consult your tax professional or a tax attorney who understands both tax code and your state laws.

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