Renting To Your Kids (Or Other Kin)
It's been called "the new normal", this phenomena of young adults moving back in with their parents.
While our economy has made strides since the crisis of a few years ago that left many young folks unable to find work, more of them are living with their parents than at any time since 1940.
Take this real life example – Mom and Dad's grown child graduates from college, moves back home, and finally finds a job. The problem is the job doesn't pay enough for him on his own to enjoy the life he currently is enjoying living with the ‘rents. So, as is human nature, instead of moving down to something he can afford, he wants to just keep living there.
Now, some would say, that's life…move! But the parents here had a "better" idea, so they thought. They were in a position to buy a home for little Billy (not the real name) in which to live. They figured their son could rent from them at a discounted rate, and they, as landlords, could deduct the loss created by such expenses on their tax return.
A win/win, right? Maybe not!
There are special rules that apply when renting property to family members that come into play, and anyone not aware of these rules might just find themselves being taxed on the rental income while some/all of their rental deductions could be disallowed.
To be able to deduct the expenses of rental property, you first have to figure out how the IRS will classify the property; it may be considered a rental property, a vacation home, or a personal residence.
Rental Property - A rental property is one rented during the year and used by the owner for personal purposes less than the greater of 14 days or 10% of the number of days during the tax year it was rented at fair rental value (i.e., not discounted).
If a home qualifies as a rental property, expenses including mortgage interest, property taxes, insurance, utilities, and maintenance expenses can be used to offset rental income. If total expenses exceed rental income, the expenses may even generate a deductible loss.
Vacation Home - When a home is used for both personal and rental purposes, and it is rented and used by the owner for personal purposes for more than the greater of 14 days or 10% of the number of days during the tax year it is rented at fair rental value, that home is considered a vacation home and is subject to special limitations.
With a vacation home, expenses such as mortgage interest, real estate taxes, etc. are allocated between rental and personal use. Rental expenses may only be deducted to the extent of rental income generated by the property. In other words, they can reduce your taxable rental income to zero, but cannot generate a loss.
Personal Residence - When a home is rented for fewer than 14 days during the tax year, the home is considered a personal residence. Mortgage interest and real estate taxes may be deducted as itemized deductions on Schedule A, and the owner does not have to report the income at all.
What about the case above? Well, when you rent a home to kin, such as a spouse, child, grandchild, parent, grandparent, or sibling, any day rented at less than the fair rental price is considered a personal use day. To avoid having the rental days considered personal, the property must be rented at fair market rates and be the renter's principal residence.
The issue above is that the parents want to charge their beloved offspring less than fair rental value. If they do this, they will have to allocate expenses between personal and rental expenses. All of the days the home is rented to the kid at less than fair rental value are considered personal days, so the rental portion is zero.
Not good! Mom and Dad would have to include all of the income received in their taxable income, but none of the rental expenses would be deductible, except for mortgage interest and real estate taxes, which would be deductible as itemized deductions on Schedule A. Yikes!
So you can see how significant it can be how the rental is classified.
My advice? The parents should charge Billy fair market rental to live in the house so as to avoid the limitations on deductions referred to above. And I would make sure that the determination of what constitutes fair rental is well documented for the IRS.
If the parents then decide, independent of the rental, that Billy needs some financial help, they can of course make monetary gifts, being aware of gift tax rules (another article another time). Such gifts should NOT, however, be tied in anyway to the amount of rent Billy pays, so as to avoid the IRS questioning the validity of the fair rental payments, potentially subjecting you to the personal residence limitations described earlier.
