As housing rents continue to rise, you may be thinking about helping family members out by renting them a residential property at a discount. Proceed with caution. Even if they are a model tenant, your generosity can lead to the loss of significant tax deductions.
Let’s look at the tax treatment that applies when you rent to unrelated parties versus how the rules change when you rent to relatives.
Business vs. personal
If you use real estate strictly for business purposes, in other words as a rental property, you must report the income and can deduct mortgage interest, property taxes, utilities, depreciation, maintenance and other expenses. You may claim a loss (subject to limitations) if your expenses exceed your rental income.
Suppose you use a property as a personal residence (such as your primary residence or a vacation home) and rent it out for fewer than 15 days per year. In that case, you don’t need to report the rental income, but you can’t deduct related expenses. If you itemize, you can still claim personal deductions, to the extent allowable, for mortgage interest and property taxes.
Now suppose instead that you rent out that residence for 15 or more days per year. In that case, it’s treated as a mixed-use property. You must report the rental income and allocate your expenses between the property’s personal and business uses. You generally can claim the personal use portion as itemized deductions. The business use portion of these and other expenses are deductible as rental expenses, but they can’t create a loss. Disallowed deductions may be carried forward to future years.
Family matters
Renting property to family members means you risk losing the ability to deduct rental expenses. That’s because use by family members is considered personal use, even if your relative pays rent, unless two requirements are met. The family member must:
- Use the property as a principal residence
- Pay fair market rent (not discounted).
If these requirements aren’t met, then you must report the rental income (if you rented the property for 15 days or more per year) but related expenses won’t be deductible.
If you want to avoid losing valuable tax benefits, set the rent at or above fair market value and document fair market rent with comparable local rental rates.
If you give family members financial gifts to help with the rent, the IRS will likely view this as discounted rent.
Know what you’re getting into
Granted, helping family members with housing expenses is a nice thing to do. Just be aware of the tax consequences.
T
his column is for information only and should not be taken as advice. Tax issues are almost always complicated and can cost a lot of time and a considerable amount of money if mishandled. Getting advice from an experienced tax professional would be prudent.
Norm Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC (www.GRILL1.com), certified public accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203 254-3880.
