Tax-Free Income from Renting Your Home to a C or S Corporation
Generally, this strategy works, as confirmed by the IRS in a private letter ruling. While our articles do not specifically discuss renting from your own S corporation, we will address it here. Renting your home to your S corporation for 14 days or less raises the following seven tax issues:
- Will the prohibition on deductions for an employee renting to the employer under the tax law undermine the strategy?
- Could the entertainment facility rules invalidate the entire strategy?
- Wouldn’t renting to your corporation fall under the vacation-home rules, resulting in the elimination of benefits?
- Would the rule disallowing tax deductions for related parties when the other party lacks income from the transaction negate the benefit?
- Will the rule disallowing deductions for personal, family, or living expenses eliminate the deduction?
- Can the rental pass the ordinary and necessary business expense test?
- Could the IRS challenge the legitimacy of this rental as a sham using the substance-over-form doctrine?
Now, let’s explore how to overcome each of these potential obstacles that may arise when your S corporation rents your personal home.
- Disallowed Deductions on Employee Rental to Employer: As an employer-owner of your S corporation, Section 280A(c)(6) disallows rental deductions for the employee who rents their home to the employer. Since you are an employee of your corporation renting to your employer, this section does not cause any issues. Under the 14-day free-rent rule, the tax code does not allow you to claim any tax deductions as a homeowner. Therefore, you do not need to worry about these deductions on your personal tax return. You are only concerned with the corporate deduction and your receipt of tax-free rental income. Additionally, the tax-free-rent section of the tax law supersedes the employee-deduction-disallowance section, further supporting this strategy.
- No Deductions for Entertainment Facilities: Be cautious and avoid renting your home to your corporation for entertainment purposes, as the entertainment facility rules disallow deductions for such facilities, which would undermine your rental strategy. However, an exception applies to the annual employee holiday party or summer picnic, where the disallowance of entertainment facilities rules does not apply. With this in mind, limit the rental of your home to business meetings, staff retreats, and employee events exempt from the entertainment facility rules. By avoiding entertainment-related rentals, you successfully eliminate this obstacle.
- Rental to Related Party (Part 1): Renting to your corporation does not pose any issues with the related-party rules. While you and your family members are considered related parties, the law does not include your corporation in this group. Thus, there are no related-party problems when renting to your corporation under the 14-days-or-less arrangement.
- Rental to Related Party (Part 2): You also do not encounter any problems with the related-party rule that denies tax deductions when the recipient related party is not required to include the income. This rule only applies “by reason of the method of accounting,” which is not applicable in this case. The law allows for the nonrecognition of income, thereby eliminating any concerns related to this rule.
- Disallowed Personal, Family, or Living Expenses: Tax laws acknowledge the use of a personal home for multiple purposes, such as using part of the home as an office or renting part of it to a third party. As long as you clearly document the rent paid and the business activity that occurred, you comply with the personal, family, and living-expense rules. By providing transparent records, you address this obstacle effectively.
- Ordinary and Necessary Business Expense: Renting your home for business meetings and the annual employee holiday party qualifies as an ordinary and necessary business expense. Therefore, you have a legitimate business purpose for the S corporation’s rent payment. While the tax-free rule does not require you to rent the home at fair rental value, it is advisable to pay a fair rental value and document it accordingly. Additionally, documenting the business activity through photos with visible processing dates further strengthens your case. By adhering to these guidelines, you overcome the sixth obstacle
- Emphasis on Substance rather than Appearance
There should be no issue if the rent paid is reasonable and the business activities are conducted. The ability to exclude the rent from taxation is derived from the law itself, so there is no room for debate. The corporation’s deduction of rent for business meetings and holiday parties is not an issue of prioritizing substance over appearance. By overcoming all seven hurdles, you can successfully rent your home to your S or C corporation tax-free.
Key Points to Remember
If you run your business as a corporation, renting your home to the corporation for 14 days or less can result in a nearly perfect tax deduction. This CPA’s recommendation is spot-on, as demonstrated by the following:
- The client’s S corporation benefits from a rental deduction of $21,000.
- The rental deduction reduces the S corporation’s income, which then passes through to the S corporation owner.
- The S corporation owner reports the S corporation income (adjusted for the rent deduction) on their personal Form 1040.
- Since the homeowner rented their home for 14 days or less, they do not have any taxable income.
To avoid any complications, remember to:
- Steer clear of issues related to entertainment facilities.
- Pay and document a fair rent.
- Provide documentation proving that business activities took place.