With an asset‑heavy balance sheet, many dealerships may choose to hold their real estate in a separate partnership and lease the facility back to the operating company, which often prefers a corporate structure. Commonly used across industries such as manufacturing and hospitality, this structure can offer liability protection and long‑term wealth planning benefits, including the ability to receive partnership basis step-up adjustments on highly appreciating assets. However, once these lease arrangements are established, it is easy for the terms to go unchanged or for formal requirements to become overlooked, particularly in today’s quickly changing economic environment.
What the IRS Expects: Arm’s-Length Standards for Related-Party Rent
Transactions between unrelated parties are typically governed by fair market value. When related parties enter into similar arrangements, the IRS expects comparable arm’s‑length terms to apply. A lease that reflected fair market value when it was executed years ago may no longer meet that standard today because of changes in interest rates, commercial real estate markets, and operating conditions.
The IRS has the authority to adjust lease terms between related parties if they don’t meet the arm’s‑length standard, under Internal Revenue Code (IRC) Section 482. And if rent is deemed excessive, the excess portion may be disallowed or recharacterized depending on the facts and circumstances. Conversely, if rent is set too low, the IRS may assess tax on imputed income without allowing a corresponding deduction at the operating entity level.
How §163(j) Affects Dealership Lease Terms
Section 163(j), enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), typically limits the deduction for business interest expense to 30% of adjusted taxable income (ATI). For tax years beginning in 2022 through 2024, ATI was calculated using an earnings before interest and taxes (EBIT)-based approach. Beginning in 2025, legislation restored an earnings before interest, taxes, depreciation, and amortization (EBITDA)-based calculation, which, in general, increases ATI and may allow for greater interest deductibility.
This creates an important interaction between rent and interest expense for related-party entity structures. If related-party rent is set below market, more income will remain in the operating entity. However, this can reduce income at the real estate entity, where debt is often concentrated, potentially limiting the ability to fully deduct interest expense paid under §163(j). Mismatches like these can result in trapped interest expense and higher overall tax liability across the ownership group over time. Periodically taking another look at related‑party lease arrangements to see if they reflect current fair market value (and to make sure the terms are properly documented and followed) is a practical step businesses can take to remain compliant, defensible, and in step with today’s market conditions.
How Forvis Mazars Can Help
Forvis Mazars works with dealership groups and other closely held businesses to help navigate the complexities of related‑party lease arrangements. Taking a fresh look at related‑party rent today can help reduce risk and enhance tax savings tomorrow. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars today.