Read This Before Leasing Property from a Related Party
It is very common for corporations to lease property from a shareholder or other related party. In fact, we advise clients to generally not hold real estate inside of corporations, but rather to hold real estate in an LLC with a lease arrangement with their corporations. Holding real estate inside of a corporation can create potential tax traps that are avoided by owning property individually or in an LLC. We’ll discuss this more in a future post.
Generally, transactions with related parties are subject to more scrutiny from tax authorities. This is particularly true in the case of lease agreements. If the IRS finds rent paid to a related party to be “unreasonable,” the deduction will be reduced. “Excessive” rent can be recharacterized as a distribution of profits, or a gift, as the case may be. Taking specific steps at the inception of the rental arrangement to support the rental rate and terms will place the related parties in a better position to defend the lease if questioned by the tax authorities.
Establishing fair rental value.
Establish the rent in your transaction in line with rent paid by unrelated parties for property that is comparable to yours. You can contact independent realtors or brokers to get appraisals based on comparable properties. Retain documentation from multiple parties to support the rent rate.
In cases where the fair rental values obtained from independent parties are below the amount you seek to set for your transaction, carefully document why your particular property should be valued higher. Consider the improvements made to the property, special features or location, etc. Rent is often viewed as a combination of a property’s value with a reasonable rate of return. You may be able to justify setting a higher rent by showing that rates of return for your particular industry or investments run higher than elsewhere.
In some cases rent is set as a percentage of profits. This acceptable technique and can be used to protect against inflation or other risk factors. However, percentage rental agreements can be subject to even higher scrutiny by tax authorities, particularly high income years. Protect yourself against a potential disallowance in such years by documentation to show that the percentage rental arrangement was reasonable when it was established.
If it’s a usual practice to use percentage rentals in your industry, keep your arrangement in line with industry standards. Document this through industry information, independent appraisals and analyses to support that the terms of your transaction are market-based when you initiate the arrangement.
Formal lease. 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.
Just because your transaction is with a related party, don’t change any of your standard business practices. From the tax standpoint it’s even more important to undertake the proper formalities for these transactions. In several cases, rent paid to a related party has been disallowed because it wasn’t required under a formal lease.
Before entering into a lease agreement with a related party, consult your tax professional and thoroughly document how the rate and terms of the lease were established.