Updated June 11, 2020
If you’re the owner of a multi-unit complex of any kind, typically, you also have an onsite property manager. Also typically, employing this person includes offering him/her lodging plus a base salary. The amount you pay your manager, of course, depends on the number of units for which he or she is responsible, the amount of work involved, and the nature of that work. The amount of “free rent” you offer is generally not a tax problem, either—IF you meet certain conditions:
- You must furnish the lodging on its business premises. In other words, where your manager lives must be a part of the property being managed.
- You must have a valid business reason for providing the housing. This usually means that you need a manager on site to respond to tenants and protect the property.
AND…
- Your manager MUST accept lodgings as a condition of employment.
All three of these conditions must be present in order to avoid tax liability. If even one of them isn’t, then you’ll need to include the net value of the lodging on your manager’s W-2 form, and the manager is required to report that income on his or her tax return.
So far, so good. You can check all these things off, so you’re in the clear, right?
Well, you are as far as federal tax liabilities go. However, federal taxation is only part of dotting the financial i’s and crossing the t’s. Don’t forget about state tax laws, or you may encounter what Tim, a recent visitor to my office, ran into.
The Good
In 2008, Tim acquired a 16-unit complex and put it in a newly created limited partnership, managed by a corporation, for asset protection. He then offered a tenant already on the premises free rent (a $600 value) in return for serving as an onsite property manager. The manager’s duties consisted of fielding tenant concerns and complaints and providing minor repairs; because the property was fairly small, no other compensation was included. A few months into his ownership, Tim decided to re-roof the building. Two of his tenants, roofers by trade, offered to do the work in exchange for six months’ free rent. The agreement was struck, and the roofing was done within a month.
The Bad
Fast forward to 2012. At this point, a young state auditor looking to make a name for herself performed an audit on Tim’s limited partnership—and came back with an assessment for Labor and Industries of $90,000. Because she didn’t understand either the onsite manager’s duties or the terms of the roofing job, she erroneously assumed that Tim had employed three people (the onsite manager and the two roofers) full time for the previous three years!
The Ugly
Now, this might seem to be a simple misinterpretation of the tax rules…but here’s where it also got more complicated (and expensive). Tim’s complex took in gross rent of $100,000 per year, and L&I assessments are one-third of that, or about $30,000. However, what Tim neglected to do was pay Workers Compensation as well. This meant that the basis for tax purposes increased to $200,000, or 25 percent of his building’s fair market value. This judgment wasn’t offset by the ownership arrangements for his building, and Tim became personally liable for it.
Ouch! Could This Have Been Prevented?
Yes, by taking these precautionary steps:
- When it comes to onsite managers, it pays to draw up a formal contract that specifies the manager’s duties, hours, and compensation—and treats the manager as an independent contractor, so that you sidestep withholding and insurance issues. If for some reason this isn’t workable, at least have your manager submit regular monthly written logs of hours worked and tasks performed.
- Set up an actual property management corporation when acquiring the property. The corporation can then hire the manager, thus providing you as an individual with additional protection, especially when it comes to imputed compensation issues connected with “free rent.”
- Above all, be informed. Before you enter into property management agreements, consult your state department of Labor and Industries first. Some states don’t allow “free rent” as the total compensation an onsite manager receives. Instead, a portion of the rent is offset against what would be considered a minimum wage owed the manager for his services—and your tax and reporting requirements would change accordingly.
No Place for Guesswork!
Owning real estate can produce some great returns—but small mistakes can wipe out those gains and cost you out-of-pocket as well. Get professional guidance and know what you need to do, ahead of time, to protect your investment.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, another great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets. One of my favorites as well is our Infinity Investing Workshop.
Additional Resources:
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