Renting Property to the Proprietor Spouse

As a Sole Proprietor it can be very frustrating when you file your tax return and have to pay 15.3% Self-Employment (SE) tax on top of your Federal income taxes. Especially if you haven’t saved or prepared for the tax. If you are married, you can reduce your overall tax liability by reducing your SE taxes. It doesn’t reduce your overall income subject to Federal taxes, but again, it does reduce your SE tax liability.

How you say??
If you and your spouse own property that is used in the course of business create a spousal rental arrangement. You can deduct rent paid to your spouse for using your spouse’s property (the joint property owned). 50% of the rent paid for property jointly owned by a proprietor and spouse is deductible. The sole proprietor deducts rent expense on his Schedule C. 50% is Rent expense and the other 50% is an owner draw.

There are 6 critical factors to consider and implement:
1) The property is titled in the name of the landlord spouse(s).
2) Any debt related to the property is in the same name.
3) The spouses enter into a written lease agreement at the Fair Market Value (FMV) rent,
4) The proprietorship issues a Form 1099-MISC to the lessor (spouse) and
5) The owner of the rent property maintains a separate checking account for the rental activity.
6) The rental income received by the spouse should not immediately flow back to the sole proprietorship.

EXAMPLE:
• You are self-employed (SELF), and maintain your office in a building you own jointly with your spouse (SPOUSE), and you have no ownership in the business.
• Fair rent for your office is $1,500 a month. You paid $18,000 (1,500 x 12 months) of rent from your business account to a joint account.
• Because the property is jointly owned, half of the rental income is allocable to the SPOUSE.
• SELF can deduct $9,000 of rent expense on your Schedule C, reducing the income subject to SE tax.
• SPOUSE reports $9,000 of rent income on Schedule E.
• Depreciation and other property expenses related to SELF’s office space are reported half on Schedule C (SELF) and half on Schedule E (SPOUSE).
• Just the $9,000 saves you $1,377 in SE Tax.

CAUTION!!
• Rent paid to a spouse in this situation is recharacterized as NONpassive income because it is income from self-rented property. Thus the income generated on the lessor/spouse’s Schedule E cannot be offset with passive losses.
• Before taking steps to minimize SE income, consider the impact on items, such as retirement plan contributions, that are a percentage of SE income.

**Thomson Reuters Tax Planning for Businesses Quickfinder 2010 Edition