If a taxpayer has more than one home, renting one to a relative may appear at first glance to be a win/win. The son, daughter, cousin or old mother would take good care of the property, and the taxpayer could help their relative by giving them a break on their rent. But the taxpayer may not be aware that the tax consequences of renting to related parties are different from renting to others and may easily trigger a trap that reclassifies rental property into a personal residence. When that happens, the result is the IRS disallowing thousands of dollars in rental expense deductions.
Some Related Party Rental Situations that May Put Your Clients at Risk
- Reduced rent: Taxpayer tries to help their adult daughter (or any other relative) by renting them a house at a rate below fair market value.
- Primary resident issues: Taxpayer rents a rental house in Lake Tahoe to their Cousin George, but he only stays in it for three months out of the year, maintaining his primary residence in San Francisco.
- A good tenant discount that’s a little too good: Taxpayer gives their relative an overly substantial “good tenant” discount.
- Gifts to help pay the rent: Taxpayer rents a house to Mom at fair market value, but then gives Mom large gifts to help her pay the rent.
Let’s explore what makes these situations risky.
How the IRS Classifies Property
Tax rules for real property vary depending upon its classification under 26 U.S. Code § 280A, Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc. Classification determines what costs and expenses taxpayers can deduct. A house may be considered a personal residence, a vacation home or rental property, and determination of that classification can be the difference in thousands of dollars in deductions.
A taxpayer cannot just decide that a property is rental property for tax purposes and treat is as they like. Under 26 U.S. Code § 280A, rental property must be rented during the tax year. Also, it may not be used by the owner for their own personal purposes for 14 days or more, or 10% of the number of days during the tax year the unit was rented at fair market value, whichever is less.
If the house qualifies as rental property, deductible expenses may include
- Mortgage interest
- Real estate taxes
- Homeowner association dues
- Landscape maintenance
It is even possible for a house designated as rental property to create a loss if the total amount of expenses is greater than rental income. But should the property lose its status as a rental property, all those deductible expenses except for mortgage interest and real estate taxes disappear.
A vacation home may be mixed use, that is, the owner may stay in it sometimes and rent it sometimes during the year. If an owner uses a house as a personal vacation home and also rents it, they may use it for personal purposes for more than 14 days or 10% of the number of days during the tax year that the unit is rented at fair rental value, whichever is greater. Expenses may include mortgage interest and also real estate taxes. Rental expenses may only be applied against the amount of the rental income. Unlike a house deemed to be rental property, a vacation home cannot generate a loss.
If a taxpayer owns a house but rents it less than 14 days during the year, then the IRS deems it a personal residence. The owner need not report the rental income, and they may deduct mortgage interest and real estate taxes as itemized deductions. They may not deduct all the other rental expenses that they could if the property was classified as rental property.
Don’t Lose Rental Property Status
To avoid the pitfalls of renting to relatives and turning your “rental property” into a “personal residence” the easiest and most surefire way is simply not to rent to relatives. However, if the taxpayer is determined, they should follow these guidelines.
1. Rent at Fair Market Value
Unless they want to lose a large part of their rental expense deductions, it’s important when renting to a related party that the taxpayer rents at fair market value. If they rent below fair market value, then every day the relative rents the property is considered the same as a day when the taxpayer personally used the property. As we have seen, property cannot be considered rental property if the owner uses it personally for more than 14 days. So, if the taxpayer rents to a relative at below market value for longer than that, the house will be pushed out of the rental property classification, and the owner will lose all deductible expenses except mortgage interest and real estate taxes.
2. Be Prepared to Prove the Rent is Fair
The taxpayer will want to gather and keep proof that the rent is at fair market value. Some ways to do this are to
- Print or scan information about similar listings with similar rents
- Get fair rent letters from property managers
- Get an independent appraisal
3. The Relative Should Use the Property as Their Primary Residence
If the taxpayer wants the property to be considered rental property for tax purposes and they rent it to a relative for the year, that relative must use it as a primary residence. Otherwise, just as with renting at a below market price, every day the relative spends in the house will be considered a personal use day for the owner. So, if the relative just stays in the house for three months out of the year but has their principal residence elsewhere, that will kick the property right out of the rental property classification.
4. Be Cautious About Using a “Good Tenant” Discount
The taxpayer may be able to give their relative a small price break by using what is known as a “good tenant discount”. Although 20 percent has been allowed in the past, that’s not a shoo-in. It’s safer and easier to defend a 10 percent discount.
5. Don’t Subsidize the Rent through “Gifts”
Once you set a fair market value for the rent to the related party, don’t then turn around and give them money gifts to help them pay the rent. The IRS may deduct the gift amounts from the fair market value rent price, and once again, a rental property classification could be quickly transformed to a personal residence classification.
For more on this topic, see IRS Publication 527, Residential Rental Property.