The truth is, if you’re not careful, renting to relatives can trigger all kinds of tax consequences you may not even be aware of. Fortunately, we can enlighten you on some red flags to look out for.
To maintain rental expense deductions you need to ensure you’re renting property. That begins with fully grasping exactly how the IRS classifies rental property.
According to the IRS, “a dwelling is considered a residence if it’s used for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days rented to others at a fair rental value.” But what does personal use mean? The IRS defines personal use as:
- Any person who owns an interest in the property
- A family member of any person who owns an interest in the property (unless it’s the family member’s principal residence and the owner receives fair rental value)
- Anyone who has an arrangement that lets the owner use some other dwelling
- Anyone using the property at less than fair rental value.
Did you catch that second bullet point? That’s what we’re going to look at more closely in this guide. But before we do that, there’s one other important thing to note: types of rentals. From the IRS perspective, there are two kinds of rentals:
Here are our top 5 tax savings tips when renting to your relatives:
Rent at Fair Market Value
- We all love our family members, but those feelings of affection cannot extend to offering them a below-market value deal on rent lest you want to trigger a tax consequence.
- If you rent below market value, and the IRS finds out, they’ll assume that the property is not, in fact, rental property and will lose its classification as such. There go your rental expense deductions right out the window.
- As much as you might want to cut your family a break on the cost of rent, it’s not worth the trouble.
Have a Paper Trail
- Like anything about taxes the best advice to keep your receipts. That means you create a paper trail to prove the rental agreement you’re operating is legitimate.
- To prove you’ve priced your rental at fair value, print out documents that show what other rents in the area are going for. Better yet, ask an appraiser to assess the value of your rental and provide written documentation. Whatever you choose, keep these documents safe so you can turn to them if ever questioned.
Don’t Subsidize Your Family Member’s Rent Via Gifts
- Everyone faces challenging financial times once in a while and when it’s family, the knee-jerk reaction can be to help them out. But you can’t give them a “gift” of money to help pay the rent.
- Do this and it immediately sends up a flare that says “you’re not charging fair market value to your tenant.” Not a good look and certainly not a good scene for your taxes.
- Instead, consider helping them out by hiring them to do work for you so you’re paying them a wage to put toward their rent rather than cutting them a check that qualifies as a gift.
Be Careful with “Good Tenant” Discounts
- Tax law doesn’t let you charge a relative a deal or lower rent based on what’s known as the good-tenant-discount.
- Per Bindseil, courts have said relatives can reduce fair market rent by 20 percent, however, most advisors will recommend avoiding the good tenant discount when renting to relatives altogether. If you’re going to do it, do no more than 10 percent of the actual rental value, as this percentage is easier to defend.
Make Sure the Property is Your Relative’s Principal Residence
- This sounds so simple, but it’s trickier than you may think. If a relative is only renting a property from you for say two months a year, that doesn’t count as a principal residence, does it? This could cause your property to lose its rental property status and cause you to have to pay taxes on the rental income.
- Add to that the additional pocketbook pinch of the property now being considered a second home meaning you can no longer claim rental deductions.
- Our key takeaway is: before you go renting to your uncle, cousin, kid sister, or grandparents, take a good hard look at the tax code and make sure your rental agreement adds up so you don’t face any taxable problems on the back end.