Be aware of the tax rules while renting property to family members
When it comes to renting your property to a family member or friend, there are a variety of issues. How to avoid IRS Tax issues renting to your family or friends needs to be addressed before you get in hot water. The biggest issue is that the IRS expects you to charge market rent. If you cut your family member or friend a deal, (renting below market value) the IRS can disallow your deductions.
If you own a vacation home or rental property, it might be tempting to rent it out to a family member for less than full price. Because you already know your family members, they may be wonderful tenants because they are more likely to be respectful of the property and to take good care of it. But too good of a deal will result in losing your ability to write off your expenses.
There are, however, certain disadvantages to doing so, such as the possibility of negative tax consequences in some cases. It is possible that you may be required to declare your rental earnings as income, but that you will not be allowed to deduct the costs of property care and maintenance from your tax liability.
If you don’t exercise caution, renting to a family may result in your home being classified as a personal residence rather than a rental property. If this happens, you will miss out on several important tax deductions. Detailed information on these deductions and limits can be found in IRS Publication 527, Residential Rental Real Estate.
Here’s what you need to do to prevent this situation:
Renting a house or apartment to your child, parent or relative who lives there as their main and personal residence is subject to fair-market rent requirements. When establishing a fair rental price, you might gather information from websites such as Craigslist where similar properties are for rent. With a rental assessment, you may also benefit from the assistance of an impartial appraiser or an experienced realtor.
Give your relatives nothing that will make it easier for them to make their rent payments. However, helping them out by giving them any type of financial assistance may backfire since the net amount of rent charged (the rent minus the gift you earn) may be less than fair-market rent, leaving the property subject to losing your ability to deduct the expenses.
It is permissible to charge a relative a somewhat lower rent under the terms of the tax code’s good-tenant clause. Although a discount of up to 20% is permissible, tax experts normally recommend using a 10% reduction since it is safer for you to explain to the IRS.
Fair Market Rent
Even though you chance your relative fair-market rent, you may make the error of converting the property from a rental to a personal residence if your relative does not live in it as their permanent address. If you rent out your condo in Arizona to your siblings for two months while they maintain their primary residence in Michigan, the unit is regarded as a second home rather than a rental property under the IRS definition.
It’s important to evaluate how renting a second home or a vacation property may affect the capacity of other members of your family to rent the space. No matter how much you charge for rent, their utilization matches your usage. Their rental service consumption counts against the 14 days of tax-free rental service, or 10% of total rental days, that are available to you.
In short, there are five things you must do to guarantee that you may continue to deduct rental property expenditures from your taxable income.
1- Set a fair-market rent and collect it.
2- Demonstrate that the rent you charge is market-rate.
3- If you’re renting to a relative, be sure it’s their primary house.
4- Don’t provide gifts to relatives to enable them to avoid paying fair-market rent.
5- If you’re going to give a good-tenant discount, make it a fair one, like 10%.
You can claim tax deductions for the rental property on your tax returns if you follow these guidelines.
When Renting to Your Children, What Expenses Can Be Deducted?
Renting to children is the same as renting to anybody else to obtain a tax break. When renting to your children, you may have income tax concerns that require you to deduct expenditures over income, but this is not due to the link. In terms of cost, it all depends on how much you charge for the privilege of working with youngsters. Start with the concept of “fair value” to have a better understanding of the potential threats which may exist in your circumstance.
Why Fair Value Is Important
According to the IRS, you can rent out your house to anybody, even your children. The only thing that counts to the IRS is whether or not you are charging your children what the IRS regards to be “fair market value.” This should cause you concern as well since it is the only thing that matters to the IRS. If the amount is less than the market value, you may have a problem.
As a result of this, home rental income generates the ability to deduct expenditures that exceed rental revenue as a loss carry-forward, which is often accessible to individuals who make money from their rental properties. The IRS, on the other hand, considers renting below the market rate to be a not-for-profit enterprise, rather than a profit-making enterprise. Any expenses that exceed the income from rentals are not able to be carried over to a subsequent year.
How This Works
Consider, for example, the little cottage behind your house, which you decided to convert into a rental property. You decide to charge your daughter $250 a month for the use of the property to make ends meet. This equates to a $1,200 yearly cost for the service. The fair market rental price for the unit in its current condition is around $600 per month. You decide to go all out for your daughter and make her place the really nice.
Your renovations, on the other hand, cost you $40,000 in total. Tax deductions of $3000 in expenditures may be claimed in the year that you make the modifications, thereby removing the $3,000 in rental revenue that you would have received. Only $37,000 of it may not be deductible in future years, according to the IRS. Because the cottage was a not-for-profit rental at the time of the modifications, this applies even if your daughter moves out after a year or two and you re-rent the cottage at market rate once she does move out.
Some Work Arounds (That Don’t really Work)
According to IRS regulations, the maximum permitted gift value for 2022 is $16,000, so you would think that charging your daughter $1,350 a month for the updated property and then giving her $16,000 in the form of a gift would be a good idea. In your letter, you expressly indicate that she has a total choice over how she spends the money. The $16,000 gift turns out to be around $20 cheaper per month than the market rent for a one-bedroom apartment in your neighborhood, even though the market rate is $1,350, for whatever reason. The fact that money is fungible means that you have no way of knowing whether the money she is using to pay you to rent is cash you gave her or money she received from another source of income.
If you’re contemplating tax evasion, you should be aware that you’re breaking the law. Avoid IRS Tax Issues can be easy if you follow these guidelines. If you are caught, you may not be charged with felony tax fraud; but, you will be required to pay all back taxes and interest related to the scam, as well as a significant penalty. The IRS will very certainly determine that the rental was not for profit, in which case you will not be able to deduct any remodeling costs that are more than the amount you received in rent from your tax return.
You may accomplish the same result by offering your children a larger-than-average rent cut in exchange for any work they do to enhance the flat. Maintaining thorough records is particularly vital if you’re paying a relative to do repairs on their rental property on your behalf.
It is entirely appropriate to rent a property to a family, notwithstanding the preceding cautions. Because they are working with someone they can rely on, both the renter and the landlord gain from this arrangement as well. It is critical to keep track of actual rental rates for comparable properties to determine the true market rate. Close family members may even be eligible for a small reduction of the “market rate,” according to the Internal Revenue Service. In one instance, the IRS granted a 20% “good tenant discount,” which did not jeopardize the organization’s for-profit status. To avoid getting into trouble with the IRS, the good renter discount should be no more than 10%.