Renting a residence to someone you're related to can take many forms. Sometimes parents with kids in college consider buying an investment property near the school so they can rent it to their student and friends. Others buy a vacation home and rent it back to their parents and siblings.
If you own a second home or a rental property, it's tempting to rent it to a relative. After all, your relations can make great tenants because you know them, and they're likely to take good care of the property.
However, doing so isn't without risks, including adverse tax consequences. For example, you could wind up having to claim the rent you receive as income but not be allowed to claim deductions for the costs associated with the maintenance and care of the property.
That's because unless you're careful, when renting to relatives the property can be classified as a personal residence, not as a rental. If this happens, you'll lose some valuable tax deductions. For information about these deductions and rules, see IRS Publication 527, Residential Rental Property.
To avoid this situation, here's what you need to do:
If you rent a house or apartment to your child, parent or other relative, and they use it as their primary and personal residence, you must charge a fair-market rent. To prove the rent rate is fair, you can get information from places where similar properties are listed for rent, such as Craigslist. You can also get a rental appraisal from an independent appraiser or a realtor.
Don't make gifts to your relatives that are designed to help them pay the rent. This can backfire because the net amount of rent charged (the rent, less the gift you make) can wind up below fair-market rent and disqualify the property as a rental.
The tax law does allow you to charge a relative a slightly lower rent based on what's known as the good-tenant-discount. A discount of up to 20 percent has been allowed, but tax advisers generally recommend using a 10 percent discount because it's easier to justify.
And even if you charge a fair-market rent to your relative, you can still unintentionally convert a rental property into a personal residence if your relative doesn't use the property as their primary residence. So if you rent a condo in Arizona to your siblings who use it for only two months while they maintain their primary residence in Michigan, the condo would be classified as your second home, not a rental property.
If the home you're renting is your second home or a vacation home, you also need to be aware of how this affects it as a rental to relatives. Regardless of what you charge for rent, their use equals your personal use. Their use goes against your 14 days of rental use, or 10 percent of rental days, when rental income is tax-free.
In short, here are the five things you need to do to make sure you can continue to claim rental property deductions:
- Charge and receive a fair-market rent.
- Have proof that the rent you charge is fair-market rent.
- If you rent to a relative, make sure the property is their principal residence.
- Avoid making gifts to help the relative avoid the fair-market rent.
- If you give a good-tenant-discount, use a reasonable discount such as 10 percent.
If you follow these rules, you should be in the clear about claiming valuable tax deductions for the rental property.