Rent to Your Corporation

If you rent property to your corporation, the corporation can claim a rental expense deduction, assuming the rents are reasonable. However, you cannot treat the rents as passive income that you could use to offset your losses from other passive activities. A self-rental rule under the passive activity loss rules specifically prohibits you from arranging this type of rental for tax benefit. More specifically, if the self-rental rule applies, then the rental income that would otherwise be treated as passive income is recharacterized as non-passive income.

If you rent a portion of your home to your employer, see Chapter 18.

Rent with an Option to Buy

Sometimes it is not clear whether payments are to lease or purchase property. There are a number of factors used to make such a determination.

Advance Rents

Generally, rents are deductible in the year in which they are paid or accrued. What happens if you pay rent in advance? The answer depends on your method of accounting. If you are on the accrual basis, prepaid rent must be capitalized (it cannot be deducted at the time of payment).

If you are on the cash basis, prepaid rent can be immediately deducted provided that prepayments do not extend beyond 12 months.

Security deposits generally are not deductible when paid because the landlord is usually obligated to refund them if the terms of the lease are met. However, if the landlord keeps some or all of the deposit (e.g., because you failed to live up to the terms of the lease), you can then deduct such amount as rent.

Gift-Leasebacks

If you own property that you have already depreciated, you may want to create a tax deduction for your business by entering into a gift-leaseback transaction. Typically, the property is gifted to your spouse or children, to whom you then pay rent. In the past, this type of arrangement was more popular, but the passive loss rules put a damper on deducting losses created by these arrangements. If you still want to shift income to your children if the “kiddie tax” is not an issue (who presumably are in a lower tax bracket than you) while getting a tax deduction for your business, be sure that you meet these 3 requirements:

1. You do not retain control over the property after the gift is given.

2. The leaseback is in writing, and the rent charged is reasonable.

3. There must be a business purpose for the leaseback. (For example, where a doctor transferred the property in which his practice was located to his children in fear of malpractice suits, this was a valid business reason for leasing rather than owning the property.)

There are other factors to consider before entering into a gift-leaseback. Consider the impact of the kiddie tax if your children are subject to it. It is strongly suggested that you consult with a tax adviser before giving business property to your children and then leasing it back for use in your business.

Miscellaneous Rentals

Some payments for the use of property that you may not otherwise think of as rentals but that may be required by your business include safety deposit box rental fees and post office box rental fees.

The Cost of Acquiring a Lease

When you pay a premium to obtain immediate possession under a lease that does not extend beyond the tax year, the premium is deductible in full for the current year. Where the premium relates to a long-term lease, the cost of the premium is deductible over the term of the lease. The same amortization rule applies to commissions, bonuses, and other fees paid to obtain a lease on property you use in your business.

What is the term of the lease for purposes of deducting lease acquisition premiums when the lease contains renewal options? The tax law provides a complicated method for making this determination. The term of the lease for amortization purposes includes all renewal option periods if less than 75% of the cost is attributable to the term of the lease remaining on the purchase date. Do not include any period for which the lease may be renewed, extended, or continued under an option exercisable by you, the lessee, in determining the term of the lease remaining on the purchase date.

The Cost of Modifying a Lease

If you pay an additional rent to change a lease provision, you amortize this additional payment over the remaining term of the lease.

The Cost of Canceling a Lease

If you pay to get out of your lease before the end of its term, the cost generally is deductible in full in the year of payment. However, where a new lease is obtained, the cost of canceling the lease must be capitalized if the cancellation and new lease are viewed as part of the same transaction.

Special Rules for Qualified Leasehold, Restaurant, and Retail Improvements

Improvements to leaseholds (by the landlord or tenant pursuant to the terms of the lease), restaurants, and retail establishments can be deducted over 15 years rather than having to be depreciated along with the building itself over 39 years. Here is what qualifies for the rule:

• Leasehold improvements. These are improvements to the interior of a building made more than 3 years after the building was placed in service. Qualified improvements do not include enlargement of the building, elevators or escalators, structural components benefiting common areas, or any internal framework to the building.

• Restaurant improvements. These are improvements to a building of which more than 50% is devoted to the preparation of and seating for on-premises consumption of prepared meals.

• Retail improvements. These are improvements to the interior of a building open to the general public for the retail trade as long as the improvements are made more than 3 years after the building was placed in service. The improvements must also not involve enlargement, elevators or escalators, or internal framework.

If you enter into a lease after August 5, 1997, for retail space for 15 years or less and you receive a construction allowance from the landlord to make additions or improvements to the space, you are not taxed on these payments provided they are fully used for the purpose intended.

Certain qualified improvements qualify for bonus depreciation at the rate of 50% for improvements made in 2016. Qualified improvement property is any improvement to the interior of a nonresidential building if it is made after the building has been placed in service (no particular time frame applies here). It does not include any improvement that is an enlargement, elevators or escalators, or changes in the internal structural framework. Unlike prior to 2016, the improvements do not have to be made pursuant to a lease.

Qualified leasehold, restaurant, and retail improvements qualify for $500,000 first-year expensing (Section 179 deduction) in 2016. The expensing option permits an immediate deduction if there was sufficient taxable income.

Lease with an Option to Buy

When you have this arrangement, are you leasing or buying the car? The answer depends on a number of factors:

1. Intent of the parties to the transaction.

2. Whether any equity results from the arrangement.

3. Whether any interest is paid.

4. Whether the fair market value (FMV) of the car is less than the lease payment or option payment when the option to buy is exercised.

If the factors support a finding that the arrangement is a lease, the payments are deductible. If, however, the factors support a finding that the arrangement is a purchase agreement, the payments are not deductible.

Inclusion Amount

If the car, truck, or van price exceeds a certain amount (which is adjusted periodically for inflation) and you do not use the standard mileage rate to account for expenses, you may have to include in income an amount called an inclusion amount. The law seeks to equate buying with leasing. Since there is a dollar limit on the amount of depreciation that can be claimed on a luxury vehicle that is owned, the law also requires an amount to be included in income as an offset to high lease payments on a vehicle that is leased. In essence, the inclusion amount seeks to limit your deduction for lease payments to what it would be if you owned the vehicle and claimed depreciation.

The inclusion amount, which is simply an amount that offsets the deduction otherwise claimed for lease payments, applies if a vehicle is leased for more than 30 days and its value exceeds a certain amount. The inclusion amount is added to income only so long as you lease the vehicle. Inclusion amounts are based on the value of the vehicle as of the first day of the lease term. If the capitalized cost of the vehicle is specified in the lease agreement, that amount is considered to be the car's fair market value. At the start of the lease, you can see what your inclusion amount would be for that year and for all subsequent years. The inclusion amount is based on a percentage of the FMV of the vehicle at the time the lease begins. Different inclusion amounts apply to cars and to trucks and vans.

The inclusion amount applies only if the FMV of the car when the lease began was more than $18,500 in 2011 and 2012, $19,000 in 2013, $18,500 in 2014, $17,500 in 2015, and $19,000 in 2016. Different thresholds applied to cars leased in previous years and to trucks and vans first leased in 2016 or in prior years.

The inclusion amounts are taken from IRS tables. (See Chapter 9 for inclusion amounts.) The full amount applies if the car is leased for the full year and used entirely for business. If the car is leased for less than the full year, or if it is used only partly for personal purposes, then the inclusion amount must be allocated to business use for the period of the year in which it was used. The allocation for part-year use is made on a day-by-day basis.

Remember that if you use your car for commuting or other nonbusiness purposes, you cannot deduct that allocable part of the lease.

Car leasing, including the advisability of leasing versus buying a business car, is discussed more fully in Chapter 9.