Beyond the Home Office Deduction: Renting Your Home to Your Business

5 Key Points

1. Enhanced Deductions: Renting your home to your business allows for larger home office deductions compared to the standard calculation.
2. Asset Protection (with LLC): This adds a protective layer between personal assets and potential business liabilities.
3. Lower Self-Employment Taxes: Deductions reduce self-employment tax burdens, especially for Schedule C filers.
4. Offset Passive Losses: Home office rental income is passive, which can offset losses from other passive income sources.
5. Strategic Tax Planning: Flexibility to adjust rent within legal limits for managing taxable income in different profit years.

Introduction

We recently discussed maximizing the home office deduction (and was quoted in a CNBC article on the topic), but for freelancers and solopreneurs who call home their office, there is another tax strategy that can lead to significant savings. By "renting" a portion of your home to your business, you may be able to access even more deductions. It might sound odd, but it's perfectly legitimate and complies with IRS guidelines. So, what are the benefits of renting part of your home to your business?

Benefits Abound

Here are some of the benefits of renting a space to yourself: 

‍

• Enhanced Home Office Deduction: Maximizing your home office deduction is the main benefit. Instead of simply deducting a portion of your mortgage interest or rent, utilities, etc., you can deduct a "fair market value" rent, resulting in a greater overall deduction for your business.
• Increased Asset Protection (with an LLC): If you operate as an LLC, renting your home to the business can add a layer of separation between your personal dwelling and your business assets, providing some asset protection if your business faces legal challenges.
• Schedule C Deductions: If you file as a sole proprietor or single-member LLC using Schedule C, the increased deductions can help lower your self-employment tax burden. This is the largest immediate benefit, potentially reducing some of the SE taxes 15.3% burden. 
• Pass-Through Entities: If your business is a pass-through entity (partnership, S-Corp, multi-member LLC), the deductions help lower your taxable business income, potentially reducing your overall personal tax liability.
• Reclassification of Income: If you are able to use a higher rent amount than the normal home office deduction, this option will lower your taxable business income and reclassify it as passive rental income on your personal tax return. This lowers SE tax, as mentioned above, but also creates income that can be offset against other passive income losses from sources such as investment property which would normally be disallowed. 

The Mechanics: Setting it Up

Before deciding if the potential savings from a tax deduction outweigh the administrative burden, it's important to consider the hassle factor. This includes the complexity of the deduction, the amount of paperwork involved, and the likelihood of errors or omissions. If the hassle factor is too high, it may be better to pursue other cost-saving measures that are more convenient and simple. If you outsource this hassle to your CPA, these additional steps may increase your tax preparation bill. 

Additionally, failing to meet the necessary requirements or accurately document expenses can lead to complications and potential penalties from tax authorities. Therefore, it's crucial to carefully evaluate the associated rules and required documentation for a particular deduction to determine its overall value and practicality. Here are the requirements for this deduction:

1. Designate an Exclusive Workspace: The space you rent to yourself must be used regularly and exclusively for business.
2. Set a Fair Market Rent: Research comparable office space rentals in your area.
3. Create a Formal Lease: Draw up a written lease between yourself as the landlord and your business as the tenant.
4. Keep Meticulous Records: Document rent payments from your business account to your personal account. Track all expenses related to your workspace to justify your deductions.

Reporting Rental Income on Your Personal Return

The rent you receive from your business doesn't disappear into a tax loophole. You'll need to report this income on your personal tax return. Here's how it works:

• Schedule E: You'll use Schedule E (Form 1040) to report your rental income and related expenses: https://www.irs.gov/forms-pubs/about-schedule-e-form-1040.
• Rental Income: List the total rent received from your business ($36,000 in our example).
• Rental Expenses: Deduct expenses directly associated with the rental portion of your home. This could include:

• Repairs specific to the office space
• Depreciation (consult a tax advisor)
• A portion of property taxes, insurance, etc.

Example: Quantifying the Savings

Imagine you have a 200-square-foot home office, comprising 10% of your home's total area. If comparable office space rents for $15 per square foot per month in your area, here's how you could potentially leverage this scenario for tax advantages:

Business Side:

• Rent Paid to Yourself: $36,000 per year ($15/sqft x 200 sqft x 12 months)
• Potential Deductions:

• Rent: $36,000
• Utilities (10% of household total): $1,200
• Repairs (10% of household total): $500
• Depreciation (consult a tax advisor)

Personal Side:

• Rental Income: $36,000
• Potential Deductions (if these were not charged to the business already):

• Repairs
• Depreciation
• Property Taxes (10% of total)
• Insurance (10% of total)

Why Consider This Approach?

• Tax Efficiency & Self-Employment Tax Savings: As a solo LLC member filing Schedule C, you're liable for self-employment taxes on your net business income. Deducting home office rent ($36,000) substantially reduces this income, lowering both income tax and self-employment tax. With a 15.3% self-employment tax rate, you could save approximately $5,508 on the $36,000 deduction.
• Clear Financial Separation: This strategy establishes a clear divide between business and personal finances. This is especially valuable for Schedule C filers, making it easier to track business income and expenses.
• Maximizing Deductions:

• Business: Rent, utility, and repair deductions directly offset taxable business income.
• Personal: Rental income is subject to different tax rules. Importantly, if you have passive losses (e.g., $10,000) from other rental properties, they can offset the rental income from your home office, lowering overall taxable income from rental activities.

• Flexibility: You can adjust the rent within legal limits to manage taxable income strategically in high or low-profit years.

Tax Savings Dollars:

That’s great, but how many tax dollars am I actually saving by doing all of this? 

• Self-employment Tax Savings: Deducting $36,000 in home office rent could save you around $5,508 in self-employment taxes.
• Offsetting Passive Losses: $10,000 in passive losses from other rentals could offset your $36,000 home office rental income, reducing your taxable rental income to $26,000. Assuming the $10,000 of other passive losses were originally suspended, you just saved another $2,500 (25% tax bracket assumption). 
• Total Tax Savings: $8,008!!!

Important Considerations:

• Passive Activity Loss Rules: Familiarize yourself with IRS regulations around passive activity and losses. While home office rental income is passive, it can strategically offset losses from other passive income sources.
• Professional Guidance: Tax laws in these areas are complex. Consult a tax advisor to tailor this strategy to your situation and stay compliant with the IRS.

Renting your home to your own business is a strategy worth exploring for freelancers and solopreneurs.  By understanding the rules and potential benefits, you could unlock significant tax savings across both your business and personal returns.

The IRS Factors

If you are interested in learning more about the rules regarding renting a part of your home to your business, you can find the IRS’s information on the topic here: 

• IRS Publication 587: Refer to this IRS resource for in-depth guidance on business use of your home: https://www.irs.gov/publications/p587
• Form 8829 Your deductions for the rented space will be claimed on Form 8829: https://www.irs.gov/forms-pubs/about-form-8829

If you have questions about maximizing the home office deduction or want to explore how a Flat-Rate Fee-Only structure can help you achieve your goals, schedule a time to talk.

Your financial well-being is too important to leave to chance. Choose wisely.

FAQ Section

Q: Is renting my home to my business complicated?

A: There's some added complexity, including setting fair-market rent, formal lease agreements, and meticulous record-keeping. Weigh this against potential savings.

Q:  How do I report the rental income?

A: You'll report the income on your personal tax return using Schedule E, along with related expenses.

Q: Are there specific IRS rules I need to know?

A: Yes! Carefully review IRS Publication 587 and Form 8829 for requirements and details.

Q: How much in tax savings could I realistically expect?

A: Savings depend on your specific tax situation, but the article provides an example showing potential savings in the thousands of dollars.

Q: Do I need a tax advisor to do this?

A: While not mandatory, a tax advisor can ensure you navigate the complexities, maximize benefits, and stay IRS compliant.

‍