If you own and rent out an investment property, you may consider a family member as the ideal tenant for your property. After all, you know their background and have a personal relationship with them—which can be more comfortable than turning over the use of your property to a total stranger.
But before you decide to rent an investment property to a family member, It’s essential to understand the tax consequences. In this blog post, we’ll explore the pros and cons of renting to family members to help you make an informed decision about whether it makes financial sense for your situation.
Understanding the basic tax rules for renting to family members
When you own a rental property, you can rent it to a family member, but there are some unique tax implications you should be aware of.
Rental property vs. personal use property
First, the Internal Revenue Code (IRC) differentiates rental property from personal-use property.
If the property qualifies as a rental, the income you receive is taxable, and you can deduct the cost of owning and maintaining the property, such as:
- Mortgage interest
- Homeowner’s insurance
- Repairs and maintenance
- Homeowners association dues
- Real estate taxes
You report the rental income and rental expense deductions on Schedule E of Form 1040.
If the property is for personal use, you can deduct mortgage interest and property taxes as itemized deductions on Schedule A. However, you can’t claim depreciation and other expenses, such as maintenance, association dues, and utilities, are considered non-deductible personal expenses.
How to maintain rental property status
Here’s how to avoid having your rental property classified as a personal-use property when renting it to a family member.
Charge fair-market rent
If you rent property to a family member, you must charge the fair rental value for rent.
You can give your family member small “good tenant discounts.” However, if you rent well below fair rental value, every day your relative rents the property at that rate, it’s considered the same as using the property for personal use, and you lose those deductible expenses.
That good tenant discount can be as high as 20%, but most professionals recommend keeping it closer to 10%, as it’s easier to justify.
So what is fair market rent? You can find out by looking at listings for similar rentals, such as Trulia, Realtor.com, or Craigslist, get advice from a real estate agent or property manager, or get an independent appraisal. It’s a good idea to document your research in case the IRS decides to audit your return. You can do this by printing or saving a digital version of similar rental listings in your area or advice from a real estate professional or appraiser.
Don’t subsidize their rent with gifts
One strategy property owners have tried to use to get around charging a fair market rent is to set a fair rental price for their family member tenant, then turn around and gift money to the tenant to help them afford the rent charged. But this strategy can backfire.
If the IRS uncovers this arrangement, it will deduct the gift amounts from the fair market rate. As a result, your rental property could be transformed into a personal residence, and you lose the ability to deduct many operating costs.
Ensure your relative uses the home as their primary residence
If you want your investment property to be considered a rental for tax purposes and opt to rent it to a family member, make sure they use it as their primary residence. Otherwise, regardless of what you charge for rent, use by your relative is considered your personal use, and the property won’t qualify as a rental property.
Tax rules for renting a vacation home
For example, say you own a condo in Florida and rent it out to unrelated people most of the year. However, your parents rent it for the winter months and live in their principal residence in New York for the rest of the year. In that case, the condo would be classified as a vacation home—not a rental property.
Under vacation home tax law, your property is considered a personal residence if you:
- Rent the home for 15 days or more during the year, and
- Your personal use during the year exceeds the greater of 14 days or 10% of the days you rent the property out at market rates.
Personal use includes use by you, your spouse, your siblings or half-siblings, lineal ancestors like your parents or grandparents, lineal descendants like children or grandchildren, and anyone who pays less than fair market value to use the home.
For a vacation home, you must report the rental income on Schedule E and prorate your expenses between the personal and rental portions. To determine your proration rate, divide the number of days you rent the home at fair market value by the total days used for both personal and rental purposes during the tax year.
Returning to the example above, because your parents use the property for more than 14 days (and more than 10% of the days it’s rented out to non-family members), the rental income you receive is taxable, and you have to prorate your normal rental expenses between personal and rental days.
On the other hand, if your parents used the Florida property as their primary personal residence for the entire year and paid a fair rental rate, all of your typical rental expenses would be tax deductible with no limitations.
Passive loss limitations
One more tricky tax rule can limit your ability to deduct expenses you incur when renting property to a family member, and that’s the passive activity loss rules.
These rules state you can only use passive losses to offset passive income. Passive activities are those in which you don’t participate materially during the year, such as renting property or being a limited partner in a business.
In other words, if you have a loss from a rental property, you can only use that loss to offset income from another rental or passive activity. You can’t use it to offset wages from a job or income from a business in which you materially participate.
It’s not unusual for renting out a home, condo, or apartment you own to result in a tax loss—even though the rental income is more than your operating costs—because of depreciation.
Renting out an investment property to a family member can be both rewarding and beneficial in certain situations. But it’s essential to understand the tax implications involved and consider the pros and cons before deciding if it’s the right move for you. If you need help determining whether your property is a rental, vacation, or personal-use property, check out our ROI page to see if you are a good fit for a complementary tax discovery session. With proper planning and consideration of all factors, you should be able to make an informed decision about whether or not renting to family members makes sense for you.