As long as the tax code has been in place, people have looked for ways to shift income, reduce their liability and increase their cash flow. And, as an owner of a small business, rent expense has been an area that has allowed some creative accounting. However, the IRS has taken notice of this area and has begun to examine rent paid to related parties. If you are paying rent to a related entity, or someone related to you, here is what you need to know.
In general, rent paid on business or investment property is deductible. In fact, the tax code doesn’t even specifically state that the rent must be “reasonable,” as it does for other deductions. However, transactions between “related parties” typically come under close scrutiny by the IRS. If rent paid to a related party is found to be “unreasonable,” the deduction will be reduced. In many such cases, the rent found to be excessive is recharacterized as a distribution of profits, or a gift, as the case may be. You will be in a better position to show that the rent paid in your transaction is reasonable if you take specific steps at the start of the rental arrangement to support it.
Establishing fair rental value
A recommended way to establish that the rent in your transaction is reasonable is to show that it’s in line with rent paid by unrelated parties for property that is comparable to yours. You should contact independent realtors or brokers to get appraisals based on comparable properties. If the fair rental values are below the amount you seek to set for your transaction, carefully document why your particular property should be valued higher. This may be the case for any number of reasons: improvements made to the property, special features or location, etc.
Be sure that your rental arrangement is set down in a formal written lease and is properly executed. Corporations should also take all appropriate formal action related to the transaction. Taxpayers often feel they can relax where the party they are dealing with is related and they don’t anticipate future legal challenges. From the tax standpoint, however, it’s even more important to undertake the proper formalities for these transactions in the event the IRS seeks to disregard them. In several cases, rent paid to a related party has been disallowed because it wasn’t required under a formal lease.
Related party transactions can be a complicated topic. Hopefully this article has helped explain a few key issues if you plan to enter into a rental agreement with a family member. Remember, be “reasonable with your rent expense,” and the IRS will be reasonable with you.