Maybe you want to work your way around deduction limits. Or maybe you’re just curious enough to wonder if you can rent your house to yourself.
Well, it’s possible to own or control a property under an LLC, an S-Corp, or a land trust, but does this mean you can lease it back?
We get that this might sound like a chance to write off your mortgage interest, utilities, home improvement expenses, and whatnot. Unfortunately, it doesn’t work that way, and there are some significant drawbacks to consider.
What are those drawbacks, and what tax implications await on the other side? That’s what this post is all about. Read on for more details!
Key Takeaways
- Buying a house under an LLC limits your financing options considerably.
- The notion of renting a property to yourself can be counterproductive because the process generates taxable phantom income.
- Business-oriented self-rentals aren’t always as advantageous as they seem since they turn the rent into non-passive income.
Why You Shouldn’t Rent a House to Yourself
While it’s possible to buy a rental property under an LLC, the process isn’t easy. Renting the house out to yourself later on only makes things harder.
Here’s why:
Filing Inconveniences
First things first, setting up an LLC isn’t exactly a walk in the park. There are legal fees and tons of paperwork to consider.
Depending on your location, the initial filling could set you back $40–$500. Add to that any extra expenses that will come up along the way, from the cost of reserving a business name to licensing fees.
To make matters worse, all that paperwork takes up precious time.
The exact duration varies from one state to the other, but the process could take around a week or 10 business days. This would lead to delays before you can even put in an offer on the property you want to buy and rent.
Financing Hurdles
Just because you pushed through the filling process doesn’t mean your troubles are over.
Buying the house is going to be a challenging feat since getting a loan is often harder for LLCs than it is for regular homeowners.
That’s because lending out to an LLC (where the members won’t face much liability if things go south) is risky for any bank or lender. You might even have to use your personal assets to back the debt and get mortgage approval.
Plus, the purchase is now considered an investment for a rental property instead of an attempt to buy a primary residence. So, you’ll probably have to face a higher interest rate than what you would expect on a conventional mortgage.
Keep in mind that FHA residential loans will most likely be off the table, which officially makes your financing options as limited as can be.
Phantom Income
For argument’s sake, let’s suppose financing wasn’t a problem, and you didn’t mind the filing inconveniences. So, you managed to buy the property under the LLC and rent it yourself. What now?
Theoretically, you should be paying rent (at a fair market rate) to the corporation every month, and that’s a quick way to fall into the “phantom income” trap.
Let me explain.
The rent payment is now considered income for the LLC—income that you, as the corporate owner, need to pay taxes on. That creates a situation where you quite literally have to shoulder a tax for the rent you paid to yourself. Can you see how that’s counterproductive?
Now, remember that the rent you, as the tenant, pay to the LLC (or any landlord, for that matter) isn’t tax-deductible. That makes the net financial outcome from this hypothetical setup even worse somehow.
Tax Break Eligibility
The rent-to-yourself situation comes with more tax complications than just the phantom income trap.
Some owners fear they could miss out on their Section 121 home sale gain exclusions.
Under normal circumstances, the 121 exclusion allows homeowners to sell their properties with a tax exemption of up to $250,000 (or $500,000 for couples filing together).
The main requirement here is passing the IRS’ ownership and use test. The gist of it is that the house needs to be the homeowner’s primary residence and that they’ve lived in it for two out of the last five years before the sale.
Technically, you could still be eligible if your house is controlled by a trust or owned by a certain single-person entity under the Internal Revenue Code Treasury Regulation 1.121-1(c)(3).
However, buying the property under your name and residing in it sans the rent is a more straightforward approach. Plus, the regulations mean that you can’t co-own the holding entity with a partner and expect to receive the 121 tax break if you decide to sell.
Self-Dealing Doubts
Last but not least, you should consider that renting to yourself can cast some doubt on your legal situation if you ever get audited by the IRS. After all, it could be seen as a form of self-dealing.
At its core, self-dealing prevents fiduciaries from conducting business with themselves or any disqualifying person, like a relative, for their own interest rather than that of the company. This covers leasing property to or from the private foundation.
The issue here is that paying rent to an entity that you own might be considered a transaction with no economic substance.
Note that self-dealing could come with additional taxes, but it’s better to consult your CPA for more details.
Readers Also Check: Can You Buy a Duplex on an FHA Loan?
What’s up With Self-Rental Rules?
Renting out a property could make sense if it’s part of a business operation instead of a residence. This means that you can lease a place that you own to a business that you also run or at least participate in.
In this case, the self-rental rules will apply, but they won’t always work in your favor.
For one, your income on the rented property will change from passive to non-passive. Yet, any losses that come up during the tax year will remain passive.
As you might know, passive losses only offset passive income in most cases. So, you’ll find yourself in what people refer to as the “self-rental trap.”
In the self-rental trap, owners can’t deduct losses from their net rental income, which they could’ve done if they had leased their property to an unrelated third party rather than their own business.
Frequently Asked Questions
Final Thoughts
Generally speaking, renting a house to yourself or going through the self-rental rules isn’t advantageous. Yet, every lease is a different case.
Make sure you get in touch with a specialized CPA to get the best advice possible for your situation.
