In 1993, the IRS lost a court case to D. Sherman Cox that shows how self-employed taxpayers can benefit by renting from their spouses. In the Cox case, the court ruled that:

• Sherman can deduct the rent he paid his wife, Maxine, as a business expense on his Schedule C
• Maxine can treat the rent as rental income on the tax return she and Sherman filed jointly
• The filing of a joint return does not impede either the rent deduction on Schedule C or the rental income on Schedule E

Tax-smart results on Schedule C: Deductions on Schedule C reduce:

• Social security taxes
• Medicare taxes
• The negative results of "phase-outs" that eliminate tax breaks like itemized deductions, personal exemptions, child credits, and passive loss deductions

Tax-smart results on Schedule E: Income on Schedule E increases allowable passive-loss deductions. Tax law eliminates passive loss deductions on rental property if:

• You are not in real estate
• Your income is greater than $150,000

However, you may always deduct passive losses to the extent of passive income. In this case, Sherman and Maxine Cox added $9,000 in passive deductions with the husband to wife rental arrangement.

Three rules combine to produce the tax savings:

Rule 1: When you pay rent for your office, you deduct that rent as a business expense. You pay social security and medicare taxes on your net business income, after you deduct rent paid. Thus, rent can produce social security and medicare tax savings.

Rule 2: You report rent income on Schedule E of your tax return. You deduct rent expenses, such as depreciation, on Schedule E. On net rental income, you pay only the income tax. You do not pay social security taxes on rent income. Further, net rental income counts as passive income and offsets or frees other passive losses.

Rule 3: Husband and wife are separate taxpayers. Even when both husband and wife own the property jointly, the husband may deduct rent paid to the wife for his use of her part. Similarly, the wife may deduct rent paid to the husband.

The IRS ruled that the husband could deduct the rent he paid to his wife for his use of their jointly-owned property. She reports the rent as income. When others tried to do this on joint returns, the IRS said "no" and claimed in various private letter rulings that the husband and wife rent deduction applied only to separate returns. In Cox, the court examined this IRS separate return nonsense and ruled against the IRS.

The amount you can save depends of your net business income and passive loss situation. For each dollar of rent expense your claim against:

• Income of $72,600 and under, you save 15.3%
• Income over $72,600, you save 2.9%.

For each dollar of passive income that you can release with the rental arrangement, you benefit by 16.5% or more in the current year.

Example 1: John's wife owns a $22,000 car. She rents it to him for $508 a month. John uses the IRS's tables to compute the monthly rent. John deducts annual rent of $6,096 on his Schedule C and that reduces his self-employment income subject to Social Security tax. He computes his savings by multiplying his 15.3% self-employment tax rate by the $6,096 rent deduction for an annual after-tax cash savings of $933.

Example 2: Jane's husband owns the family home where Jane keeps her office. Jane pays rent of $1,000 a month for office space. She saves $1,836 in Social Security taxes at the 15.3% rate.

Reminder: Jane probably saves more, possible much more than 15.3% when she considers the savings from the various phase outs. For example, Jane's new rent deduction can free tax savings from phase outs of:

• Child credits
• Itemized deductions and persoanl exemptions
• Rental property losses
• IRA deductions

Does your situation lend itself to rent deductions similar to John's and Jane's rent deductions? Ask yourself: what assets do I need in my business? Your answer may include:

• Car
• Desk
• File Cabinet
• Chair
• Computer
• Printer
• Office Space

You can easily create a much longer list of possible business assets.

Key: Do you need the assets in your business? If so, can you rent those assets from a retail rental company? If "yes," you can rent it from your spouse.

Caution: Pay fair market rent for the business asset or lose the business deductions. Further, you need to dot the "I's" and cross the "T's" or the IRS will throw out the deductions.

To make the rent-from-your-spouse strategy stand up to IRS scrutiny, you need to prove that:

• You physically paid fair market rent for the assets supplied by your spouse
• You and your spouse signed a written legal lease
• Your spouse received the rent payment and deposited them in his or her sole and separate account
• Your spouse purchased the assets from his or her separate funds, or, alternatively, that your spouse can prove that he or she truly owns the assets rented

Strong evidence: If you had to and then paid any applicable state sales or use taxes on the rentals, you help establish a strong case for true rent, establish a strong case for true rent.

Pay the rent: If you want your lease treated as a lease for tax purposes, you and your spouse must act like independent business people. Pay rent each month or quarter, just as any business would make payments.

Make sure that you can produce canceled checks and signed copies of the lease. you must have proof of rent payments to audit-proof your rent deductions. You should pay rent from your separate business checking account. Your spouse should deposit rent receipts in a separate business account.

Make sure you keep your canceled checks. If your bank wants to keep your canceled checks, find a different bank.

You must have proof of fair market rent or you risk losing the deductions. Basically, the rent you pay should equal what you would pay an unrelated third party for the same equipment.

For a car, you can find the IRS's official fair market rentals in its regulations. Alternatively, you can establish fair market rents with statements from auto dealers and leasing companies. If your rental involves a used car, you can find used car rental rates from such companies as Rent-a-Wreck and Rent-a-Lemon.

Tax smart: Short leases call for higher monthly payments and higher profits to the lessor. Thus, you pay more rent each month on one-year lease than you pay on a four-year lease.

For equipment, furniture, and computers, contact commercial establishments that rent such items, new or used, and document fair rental values. It may be appropriate to take photos of furniture that looks similar to the office furniture you plan to rent from your spouse. Should you take the photos, have the photos developed by a film processor that date stamps the photos.

Written lease: The lease must an be enforceable legal instrument to stand up to IRS scrutiny.

You can obtain model equipment leasing agreements from your local office store or have your attorney draft one for you. Make sure the terms are similar to those required by third-party lessors. If two months advance rent is normal, your lease should require two months rent in advance. If a deposit is normal, your lease should require a deposit. You want both a "normal" and a "written" lease.

Spouse's bank account: your spouse should deposit rent receipts into a separate bank account. Your spouse should not connect your name with the separate account. Do not make the rent account a joint account because the IRS could then claim that you paid at least half the rent to yourself.

Your spouse must have sole and separate authority over the rental account. Further, your spouse should keep this account separate from personal and household accounts because you want the account to look and feel like a business account.

Your spouse should not use the separate rental account for personal purchases. When your spouse wants the rent money for personal purposes, he or she should withdraw money from the rental account and deposit that money into the personal account. One good rule to follow is "never" pay personal expenses from the rental account.

Checks should always be deposited intact within a week of receipt. If rents are due on the first of each month, they should be paid by you on the first and deposited by your spouse before the eighth. Again, remember, you want the rental transactions to have the look and feel of business transactions.

Spouse purchase and ownership: Your common sense should tell you that your spouse should buy and own the asset that you will lease. In the IRS's ruling on the Wisconsin man, there is no mention of how he and his wife acquired the property. The ruling states only that it was jointly-owned property in the State of Wisconsin and thus one-half the wife's property. Therefore, the IRS ruled that the husband could deduct the rent he paid to his wife for his use of her one-half of the property. Thus, although it's best that your spouse buy and own the asset, the rules of joint tenancy and community property can provide adequate basis for deductions.

If you own property and want to give it to your wife, make sure you put the transfer in writing. If you gift the car, your spouse should register the car in his or her name.

State sales and use taxes: Most states charge sales or use tax on rentals. In such cases, the rental company does not pay sales tax on the purchase of the asset because the property will be used in its rental operations. Instead, the lessee pays sales tax to the lessor who remits to the state. There are several things to consider in this regard:

• Does your state impose a tax on rentals?
• Are rentals between husband and wife exempt from sales and use taxes?
• Can you pay the tax in advance? Annually? Quarterly?

If you are subject to the tax, timely payment is strong proof that the rental is a business deal. Again, as with all proof, keep copies of the correspondence, forms, and canceled checks that you file with the state government.

Summary: You must pay attention to the documentation when you set up the pay-rent-to-your-spouse strategy. Tax law considers you and your spouse related parties. The relationship subjects you to more than normal questions on your rental arrangement should the IRS ever knock at your door. You help insure your deductions when you pay careful attention to the details discussed in this article.