Can I pay my spouse to manage my rental property?

[vechinsj]

My wife and I jointly own a duplex. She does most of the management work...advertises, reviews tenants, answers tenant's questions/issues, etc. Can I pay her a management fee and then deduct that from the rental income next year? Would it make a difference if I was sole owner of the renal property?

[ChelsiE2 · Accepted solution]

If your wife also owns this rental property, then no, you cannot pay her to do this work.  

If you owned this property separately and held it in a separate entity such as an LLC, you could pay her to manage this property but it's not a good idea.  Paying her would only move this income from Schedule E to Wages and Income.  You'd also have to pay FICA taxes or Self Employment Taxes on these amounts.  It is not advantageous for you to do this.

[ahsoka11]

Hi chelsie! I wanted to do this. My rentals are in llc so I wanted to pay myself with a 1099 from the rental so I can deduct self employed health insurance. What do you think

[Anonymous]

I've been thinking of doing this myself and having 100% of the proceeds go directly to a solo 401(k) for my stay at home spouse.  The LLC (employer) matches my spouses contribution - both pretax - to reduce income on the Schedule E and reduce self-employed tax from the 1099.  Not sure this is kosher or "self-dealing".  So I need to look into this more.  

[Carl]

The below is an opinion (mine) based on research, facts and personal first hand experience.

Putting a rental property into a single member LLC is probably the absolute worst thing you can do. It's not just an tax issue either. There are other more important reasons that have absolutely nothing to do with taxes.

Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Nothing could be farther from the truth.  If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. That “veil of protection” supposedly offered by an LLC is so thin, even a new first time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. If fact, many law firms will give these types of cases to their newest lawyers (representing the tenant/plaintiff) because they're practically guaranteed to win. There are other problems and issues with this too.

In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash on hand to pay for it in full, your LLC will never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you, that’s not going to happen.

When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a rental property produces “passive” income. What’s the difference?

Earned income is income which you have to do out and “do something” in order to earn it. This income is subject to regular income tax, and also an additional 12.6% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.

Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.

SO if you create an LLC for your rental property, there are two things that will NOT happen.
 - You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
 - You will not report one penny of rental income or one penny of rental expense on SCH C.

So in the end, you will be filing a zero income/expense SCH C with your personal tax return.

Now let’s say you decide to file the 8832 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on SCH E as a part of the 1120-S Corporate Return, and you will also report the K-1 on SCH E as a part of your personal tax return. But keep in mind that this is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 8832 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.

SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan.  Overall though, it’s still financially dumb to do this. Here’s why I say that.

When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time.  A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.

One mistake I see quite often is that when an owner converts their primary residence or 2^nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case.  If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.

[Anonymous]

Thanks Carl.  A couple notes: The rental property is not under mortgage and has already been transferred to the LLC.

I understand and have been advised regarding the thinness of the veil we've created; we have tried to mitigate that by keeping all finances as separate as possible (via adding the LLC as add'l insured on all rental dwelling insurance policies, opening business checking/savings accounts in the LLC's name, and putting all utilities under the LLC).  We have a $5M personal umbrella policy as well.  It's not perfect but something that we chose to do, and felt it was worth it after weighing the pros and cons in consultation with a  friend that is a real estate attorney.  

I also realize that rental property income is passive and therefore on schedule E.  ***My question was whether contracting to my spouse (a non-owner of the LLC) to manage the property, and thereby creating self-employed schedule C income for spouse from management fees, is something to explore to open up some add'l avenues to access tax-advantaged retirement accounts.***  I'm not super savvy with SEP IRAs or solo 401ks or self-employment tax rules but I think deducting the "management expenses" from the Schedule E would potentially cancel out any incurred self-employment taxes and especially if we contributed 100% of the schedule C "management income" to a pretax retirement account.  

[Critter]

Ok... I agree with Carl ... BIG mistake to do what you are thinking about doing and I highly recommend you talk to a local professional tax pro to get educated on this "tax plan" that no one does because it makes no financial sense to do so.

One flaw you are not understanding is the Sch E deduction negating the Sch C income ... it does for federal taxes but not for the SE taxes so it will cost you 15% in SE taxes to follow this idea.  

[Carl]

has already been transferred to the LLC

Not a problem on that front since there's no lender/lien holder to deal with. But if it's a single member LLC of which you are the only owner, then that LLC is reported on SCH C as a physical part of your personal 1040 tax return - even if it's a joint return. However, did you par chance file IRS Form 8832 with the IRS to treat the LLC "like an S-Corp" for tax purposes? Please let me know because if you did, then we're both wasting time talking about LLC stuff when we should be talking about S-Corp stuff. As far as I'm concerned, when you make the 8832 election to treat an LLC like an S-Corp, then we need to be talking "S-Corp" and forget about all this LLC stuff. It just leads to incorrect assumptions, invalid, incorrect and just flat out "WRONG" information being provided to you.

[tagteam]

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@Critter wrote:

One flaw you are not understanding is the Sch E deduction negating the Sch C income ... it does for federal taxes but not for the SE taxes so it will cost you 15% in SE taxes to follow this idea.  

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@Anonymous I agree with @Critter with respect to the "flaw" quoted above.

Moreover, your proposed plan actually violates a codified principle known as the economic substance doctrine. In short, your planned "transaction" would have to change your economic position in a meaningful way and you would need a substantial purpose apart from the federal income tax effects.

It is fairly clear that your sole purpose would be to alter the federal income tax effects and does not change your economic position in a meaningful way (again, other than the tax effects).

I.R.C. §7701(o)(1):

(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayers's economic position, and

(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

[Tdamjan]

What if I am sole owner of the property (purchased prior to getting married) and I don’t pay my wife directly but pay her through an incorporated property manager firm that employs her. Does it matter if she is the single employee or not?

[Critter-3]

@Tdamjan

Your situation is not the same ... your Sch E rental legally  pays a corporation to manage the rental  property and that corporation legally  employs your spouse and they file the proper payroll reports.  

[Carl]

My wife and I jointly own a duplex.

The bottom line answer is no, an owner can not pay themselves to manage rental property they own. Doing so makes no sense anyway. You collect rent, put it in your self pocket and pay taxes on that income. Then you pay yourself by removing the money from your left pocket, putting it in your right pocket and paying taxes on it *again* with the addition of social security and medicare tax. Not only is that going to raise flags at the IRS that will result in an audit, but it's also illegal.

Would it make a difference if I was sole owner of the renal property?

Then you could legally pay your wife a management fee that you would report by issuing here a 1099-MISC. But for that to be legal she would have to agree to file a quit claim deed on the property, and chances are the lender who holds the mortgage would not allow that, as it would be a direct violation of your loan agreement possibly resulting in an immediate foreclosure on the property. 

Your wife would then report that income on SCH C as a part of your joint tax return. Then, in addition to paying taxes on it again with the social security and medicare tax, she would also pay an additional 15.6% self-employment tax. 

So if you and your wife have no problems with paying more taxes, then by all means go for it, after getting written permission from the lender to remove your wife from the property ownership deed.

[Tdamjan]

I think you misunderstood it. I bought the rental property prior to getting married, from my understanding I need to claim any rental income on this property in my own return and cannot income split with my wife. My wife doesn’t work and I want to get her to take on the management of this property and wonder if by incorporating and paying a firm (her firm) and she manages the property I can write off the expense reducing my tax owing and then her self employed firm would get taxed at a rate potentially lower than my current tax rate. 

[Anonymous]

is there any reason you think you can't file a joint return with your spouse even though she has no income?  it makes no difference that you acquired the property before you were married.  a married couple can file a joint return but must report all their income on the one return. if you were to file as Married Filing Separate you would end up paying twice the income taxes than on a joint return. economically what you would like to do makes no sense and I agree with others that the IRS wouldn't buy it.  

"incorporating and paying a firm (her firm) and she manages the property I can write off the expense reducing my tax owing and then her self employed firm would get taxed at a rate potentially lower than my current tax rate"   

say a Corp.  it would have to pay her a salary and it probably has to be almost as much as the management fees you paid it - after all you would be paying it for the services it performs and she is performing all the services. Between her and the corp they would pay 15.3 % in social security taxes + unemployment taxes. Since she would be an employee, in most states the corp would have to buy workmen's compensation insurance and if she uses a vehicle possibly higher insurance for that.  To play it safe possibly liability insurance.  Her salary would be included on your joint return (married filing separate would most like result in much higher combined taxes). the corp would have to pay federal and state income taxes assuming anything is left after expenses. Most states require Corporations to pay franchise taxes. The management fee you paid the corp would have to be reasonable (as I have said I don't think the IRS would buy this as legit which would cause you more tax problems). how much do you really think you could pay her?  management duties should only take a few hours per week  

[Critter-3]

@Tdamjan 

If the corp your wife "works"  for has ONLY your rental property as a client then this is not a wise choice ... as mentioned by others this may not be allowed by the IRS and you will convert passive income into earned income and SE taxes (and others) will need to be paid on it ... in the long run you will pay more in taxes between you both and costs/efforts will also be increased.