With the limitation on itemized deductions there are several schemes floating around for circumventing the tax code. One of the more popular schemes is the idea of a self rental, or the ability to rent to yourself. Think about it – if I won’t be able to itemize in 2018 due to the doubling of the standard deduction and the limitation on the state and local tax deduction there must be some way I can get a tax benefit from home ownership.
Why not put my home in an LLC and rent to myself? The LLC will get to deduct all the mortgage interest, real estate taxes, utilities, etc. Wouldn’t this be a great idea? Unfortunately, and quite obviously, this doesn’t work out like you may think.
Phantom Income/Losses
The main reason why renting your own home to yourself doesn’t work is because it creates phantom income and phantom losses. Let’s say you want to put your home in an LLC and rent the home to yourself for $1,000 per month. That $1,000 per month is not a deduction on your personal return and is instead rental income on your LLC. If you don’t have enough expenses to offset that rental income then you just created phantom taxable income.
Well, what if your expenses exceed your rental income? If your expenses exceed your taxable income then you’ll run into passive activity loss limitations. If you don’t have passive income to offset those passive rental losses then chances are you’ll have non deductible losses. Even if you did have passive income there are special IRS rules that prevent taxpayers from benefiting from self rental losses. Therefore, you’ll either have non deductible losses or create taxable income.
Renting to Yourself Could Create a Mess in the Future
Even if you were to run your self rental at a break-even you would still run into major tax problems in the future. If you have a self rental then chances are you’re taking a depreciation deduction on your home to offset the rental income.
This depreciation deduction slowly reduces the tax basis in your home which increases your taxable gain upon sale. Even worse, when you sell the home you will have to pay tax at ordinary income tax rates on the lesser of the gain from the sale or the depreciation previously taken.
If you didn’t have a self rental but instead owned the home you would be able to sell the home tax free. If you lived in the home for 24 months out of the proceeding 5 years you would may be eligible to deduct up to $250,000 in capital gains ($500,000 if you’re married filing jointly) from the sale of your home. Therefore, it makes no sense to have a self rental on your home in this situation.
When Does a Self Rental Make Sense
The ideal form of a self rental is in a legitimate business operation. For example, let’s say you own a barbershop and also own the building in which the business operates. This is an ideal scenario where it is beneficial to separate the building from the actual business.
Since rent is both an allowable business deduction and taxable rental income you won’t create phantom income or losses. Instead you are just moving a portion of your profits from business income to rental income. This will not only reduce self employment tax but will also limit your liability.
If you separate the business from the rental property then you create a separation of liability. If the business goes under then you can safeguard the building. Vice versa, if there is a lawsuit or lien against the rental property they won’t be able to come after the business assets.
Want to Rent to Yourself? Consult With a Tax Advisor
Before you create a scheme to avoid paying taxes, consult with a tax advisor. Chances are your CPA knows more about taxes than your late night google searches. To protect yourself from unnecessary liability, consult with a tax advisor to see what strategies are best for your unique tax situation.
For more articles on tax policy in general, check out this section of our site!
Hi Mr. Ramos. Need some tax advise. I’m a physician and I lease office space in a medical office building that I don’t own. I just purchased an old medical office building that is currently being renovated. I plan to move my medical practice to that new location. I don’t want to fall into the “self rental rule” trap and get audited. I want to know can my medical practice pay rent to the LLC that owns the building and still be able to deduct the rental expense, assuming it’s fair market value? If the net rental income on that LLC is a loss (PITI + deprection is > rental income), from what I’ve read about self-rental rules, it will still be considered a passive loss. If so, will be it be able to gobble up passive rental gains from other properties I own?
Hi Victor, great question! The situation you’re describing is when a “self rental” actually works. Setting up a separate LLC for the real estate property is a great way to keep the rental property separate from the medical practice.
Don’t forget to setup a separate bank account in the new LLCs name and pay monthly rent from the medical practice to the LLC. This wil reduce the chances of any issues in the case of an audit or legal dispute.
In regards to passive losses, if you had passive rental income from other properties then you would in most cases be able to take those passive losses. Also note that the rent paid to the LLC is a business expense for the medical practice and can be taken against income.
This of course is assuming the general rules apply. If you’d like to discuss the matter in more detail feel free to contact me at thedailycpa@gmail.com and we can setup a phonecall.
Hope this answer helped!
What about a situation where I know I’ll only live in the house for 2 years, but subsequently turn it over to becoming a rental for others?
Hi Kevin,
In the situation you described you’d have personal use of the property followed by rental use. Once the property shifts over to rental use then you can take qualified business deductions against expenses like any other legitimate rental property. The only thing you want to look out for is the potential loss of capital gains exclusion from the sale of a personal residence.
Kind of like kevin said.. Its a rental property And I have the funds for the rental property.. example.. I buy the property. duplex mortage on it is 500 but I pay 800 on it and have a renter for the upper unit they pay 800 as well. When I can get someone to rent out the bottom unit.. I can leave… Only intent is to jump start the revenue coming in since ill still have a regular job at this time until i ultimately have enough.
Hey there,
I have a paid for primary residence. I want to create an LLC and transfer ownership under this LLC for asset protection. Do I just not claim this under tax purposes since we’re not really renting it out? How do I go about paying the utilities? Since there is no rent coming in, it might show a loss since money paid out for utilities is money going out and no rent money coming in.
Pingback: Do You Have to Pay Taxes on Rental Income? -
This was hands down the best line. Literally LOL’d “Chances are your CPA knows more about taxes than your late night google searches.”
If I had self rental. Should I depreciated my property under Schedule E ? Is it mandatory requirement when you have a rental income in Schedule E, and deprecation had to take.