Most of the time, rent paid for the use of business property is deductible. In fact, the tax code doesn’t even specifically state that rent paid must be “reasonable,” (a tax term applied to most deductions). However, transactions between “related parties” come under closer scrutiny by the IRS because of the potential for abuse. 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 treated as a distribution or a gift.
You will be in a better position to show that the rent paid in your transaction is “reasonable” if you take these specific steps.
One way to establish that rent paid is “reasonable” is to show that it’s in line with rent paid by unrelated parties. Accordingly, you should obtain independent rental information.
If the fair rental value, indicated in this independent information, is 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.
Rent is often viewed as a combination of a property’s value and 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.
Taxpayers sometimes seek to set rent as a percentage of profits. This is a perfectly acceptable technique and can be used to protect against inflation or other risk factors. Where this approach is taken, however, there is a greater possibility that rents will reach unusually high levels, i.e., in particularly high income years. To protect against a potential IRS disallowance in such years, it’s important to show that the percentage rental arrangement was “reasonable” when it was established. Accordingly, advance planning is strongly advised in these instances.
Finally, be sure that your rental arrangement is documented in a written lease and is properly executed. Corporations should take all appropriate formal actions related to the transaction.
Taxpayers often feel they can relax when the party they are dealing with is related. From a tax standpoint, however, it’s even more important to undertake proper formalities for these transactions. If you have any questions or concerns pertaining to proper tax formalities pertaining to rent paid to a related party, fill in the form below and one of our experts will be in touch.