Before You Rent to Family, Read This!
Renting a house to family or friends at a discount is commendable, but it can come with some stiff tax consequences if you're not careful. This article is not meant to discourage people from doing favors for others, but before you do, there are a few things you should know.
The first thing to understand is the way expenses must be divided. If a rental is held out for rental all 365 days per year, all of the expenses for it can be deducted against the income. But for properties that have both rental and personal use, the expenses must be divided according to days used for each purpose.
As an example, if I have a second home in a vacation area that I rent out 90 days per year, and the rest of the year I either vacation there myself, let family use it for free, or it sits vacant and not held out for rent, I get to deduct roughly one-fourth of the total expenses of that house (90/365) against the rent income on my tax return. Note, a home used more than 14 days for personal purposes can fall under vacation home rules, in which case deductions may be limited to income in addition to other rules. However, for this article, we will focus on how expenses must be divided between personal and rental use.
Here's the big thing to remember: for dividing expenses, a day counts as "rented" only if the property is rented at fair rental price on that day. This means that if I charge someone substantially less than fair rental price, or in other words if I give someone a big discount on rent, I have to report the income and pay taxes on it, but I do NOT get to deduct any expenses for it. Yikes!
In our example above, let's say that for those 90 days, it was a family member that I charged $600 per month to help them through a hard time, but the rental was really worth $1,000 per month. I get zero deductions against that $1,800 of income since I charged substantially below fair rental price.
If someone is doing this on a more permanent basis, the difference in tax can be huge. If a rental is worth $1,200 per month with $700 per month in expenses, that's $6,000 in taxable income from that rental per year. But If I'm charging rent to family (or anyone else) at $800 per month, which is substantially below fair rental price, I can deduct nothing, and my taxable income for the year from that rental is $9,600.
It's a taxation double whammy; I get less in rent income and don't get the deductions. The only exceptions to this would be the few deductions, such as mortgage interest and real estate taxes, that are deductible on Schedule A only if you itemize.
IRS Publication 527 states, "The rent you charge isn't a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area." It gives five questions to determine if a property is comparable to yours:
- Is it used for the same purpose?
- Is it approximately the same size?
- Is it in approximately the same condition?
- Does it have similar furnishings?
- Is it in a similar location?
These questions help guide us on what to charge if we want to deduct expenses.
These are things we should know before giving family or others big discounts on rent. Again, renting at a steep discount is noble, but you might be giving a little more than you think in the form of lost tax deductions. Contact your EGP advisor if you need assistance applying these rules to your specific situation.