When You Rent To Family Members
Charlene M. Ives, CPA, PC
Saturday April 01, 2006
The best results come if you rent to a related party (family member) with the family member paying rent to you at fair market value. In this case, you get to deduct all mortgage interest, real estate taxes, property insurance, homeowner association dues, and any other ordinary and necessary expenses to maintain the property, plus you may depreciate the cost of the building. After all these deductions, you may well get to deduct a net loss, which reduces other taxable income. When you sell the property, you have capital gain (there is no gain exclusion assuming you have not lived in the property yourself and do not qualify for the gain exclusion).
The worst case scenario is this: you rent to the family member at less than fair rental value, or at no rent at all. In this case, you are subject to the vacation home rules, and you may only deduct expenses up to the amount of rent you have received, with the rest, being nondeductible personal expenses. The mortgage interest becomes investment interest, and the deduction for investment interest is limited to investment income (interest÷nds&capital gains). If you sell the property at a loss, the loss is nondeductible (personal loss). Of course, if you sell at a gain, that is taxable (the IRS has this game rigged).
Some people buy homes for family members to live in, and fail to become aware of the traps (particularly charging small or no rent). Also, some people will suppose they will get the residence gain exclusion on these types of properties, and that doesn't work either, because it is the owner who has the requirement to own, use, and live in the property for 2 of 5 years. So, you need to think short-term and long term as well.
Short term: Charge a fair value rent; there is a tax court case that did allow a 20% discount on rents to a family member, and still stay within fair market value in the eyes of the IRS. But if you do this, be sure to have substantiation (comparable rent values, other other substantial support for your rental amount). Charge a fair rent, and you will get favorable year-to year deductions on your tax return.
Long term: Understand you do not get a residence gain exclusion, and of course your family member who rents does not either, because he or she does not own the property. You have capital gain when you sell; but understand that depreciation will drive down your basis, and drive up the gain when you sell. However, you will get a favorable capital gain rate over the long term.
Are you planning to sell the property eventually? You could sell at an advantageous time, to your family member. The family member could then continue to live in, and would own the property, use the property, and live in the property for at least two years, and eventually qualify for the gain exclusion.
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