I am looking into building another building on my farm and looking at options. I was curious about the lease option for a building and the tax benefits associated with that method. My question is what is the lease residual that I need to maintain in order to keep it as a true lease for taxes?
You need to be sure that the “rental business” can cash-flow itself. When there is rental income between related parties, the IRS rules are backwards – that is, losses are not fully deductible (limited to $25K per year), and profits are not passive (meaning, profits will be subject to SE tax).
The popular thinking is that you can rent a building you own to your operational entity and have passive income (not subject to self-employment tax) or be able to claim losses that are a tax benefit to you. Both assumptions are incorrect (or, more accurately, “incomplete”).
As you structure the relationship between yourself and your operational entity, be sure you can cash flow with a loss of no more than $25,000 per year. $25,000 sounds like a lot, but remember that there is building depreciation to add to the cash flow profile, and an expensive agriculture building might generate a depreciation deduction approaching $25K per year.
Any loss you cannot deduct is carried over into the next year (and so on, for 15 years or until used up, whichever comes first), so if you run the lease agreement too “lean” you might generate losses that are difficult to use.
Finally, be sure that any rents and terms are “reasonable.” Unreasonable rental agreements between related parties are frowned upon by the IRS, and they will reverse any “benefit” you might think you are getting by over- or under-charging rent.
If you are trying to decide whether to launch an entity just to own a building that you rent to yourself, note that there are reasons for having a building in another name from your operational entity other than for a tax benefit to the rental entity:
– sheltering the building from the liability that might be incurred by the operational entity,
– allowing flexibility in use (expansion, sale, whatever) of the building that is independent of the operational entity,
– and giving some deductible expenses to the operational entity in the form of deductible lease payments.