Sole proprietorships (including single member LLCs) have to pay self-employment tax of 13.3% on their business income. Rental income from real estate is generally not subject to self-employment tax. An interesting strategy exists when a proprietorship rents property that is jointly owned with his or her spouse.
When a proprietorship leases real property that is owned by the business owner and her spouse, the business owner may claim a rent deduction equal to the ownership percentage of her spouse. For example, if a business owner and her spouse each own 50% of a building, the business owner may deduct 50% of the rent expense. This deductible 50% represents the spouse’s 50% ownership interest in the property. The business owner cannot deduct the 50% of rent that she essentially pays to herself.
Example: Wilma, a sole proprietor, has a legal practice that is run out of an office that she jointly owns with her husband, Fred. Wilma pays $10,000 per year in rent to herself and to Fred. Wilma may claim a rent deduction of $5,000 for the rent that is deemed to be paid to Fred. She may not deduct the $5,000 rent she is deemed to have paid to herself.
Notice that the $5,000 deduction does not reduce their overall taxable income—the $5,000 Wilma deducts is equal to the $5,000 of rental income Fred receives. However, Wilma’s business income is subject to self-employment tax, but Fred’s rental income from real property is not. The $5,000 deduction reduces Wilma’s self-employment tax by $614. This strategy basically allows income to be exempted from self-employment tax by shifting it from being self-employment income to rental income that is not subject to self-employment tax.
In addition, Fred may deduct his share of the building’s depreciation, property taxes, interest expense, and other operating expenses. Although Wilma cannot take a rent deduction for her 50% ownership, she may claim a depreciation deduction for her 50% ownership of the property plus her share of property taxes, interest expense, and other operating expenses. Wilma’s property expenses will also reduce her self-employment income.
Example 2: Same facts as above, except that Fred owns 100% of the building. Since Wilma owns no portion of the building, she may deduct 100% of the $10,000 rent expense she pays to her husband. Her husband will report the full $10,000 as rent income. Wilma’s self-employment income is reduced by $10,000, saving her $1,228. Fred will claim depreciation, property taxes, interest expense, and operating expenses for his 100% ownership of the property.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230