Renting to Relatives: 5 Tax Tips Every Homeowner Should Know

Renting a home to a family member can be a practical solution for both parties involved, but it comes with unique tax considerations. Whether you are providing a home for a parent, child, or sibling, it’s essential to understand the tax implications to avoid unexpected consequences. This guide explores the tax rules you need to follow when renting to a relative and how to ensure you remain compliant with IRS regulations.

If your tenant is related to you, special rules and limitations may apply.

What defines renting to a “related” tenant?

Renting to a relative includes your spouse, child or grandchild, parent or grandparent, and siblings.

Tax Consequences of Renting to a Relative

When you rent a home to a relative, the general tax rules for rental properties apply, but with specific limitations. 

1. Fair Market Rent: You must charge a fair market rent to your relative to retain the tax benefits associated with rental properties. Renting at a discounted rate can lead to the property being classified as a personal residence, resulting in the loss of most rental expense deductions.
2. Principal Residence Requirement: For your relative to qualify the home as a rental property, it must be their principal residence for the year, not a secondary or vacation home. This requirement helps ensure that the property is treated as a rental for tax purposes.
3. Expense Deductions: If the above conditions are met, you can deduct normal rental expenses such as mortgage interest, property taxes, maintenance, and depreciation. However, these deductions are classified as passive losses, which may be subject to passive loss limitations. 
4. Personal Use Days: Renting the property to a relative at a rate below the fair market value results in all rental days being treated as personal use days. Consequently, you must report all rental income, but you cannot deduct any rental expenses except for mortgage interest and property taxes, which are deductible for personal residences.
5. Good-Tenant Discount: The IRS allows a modest discount (up to 10%) on the fair market rent under the good-tenant clause. This provision can help relatives without jeopardizing the tax treatment of the property as a rental. However, providing financial gifts to assist with rent can be seen as subsidizing the rent, which may disqualify the property from being considered a rental.

Example: Renting a Property to a Relative

Scenario: Jane owns a rental property that she decides to rent to her son, Mark. The fair market rent for similar properties in the area is $1,200 per month. Jane charges Mark $1,000 per month, providing a slight discount due to their familial relationship.

• Fair Market Rent: Although Jane offers a $200 discount, she documents that similar properties rent for $1,200 per month and explains the reason for the discount, ensuring it is within the acceptable 10% range.
• Principal Residence: Mark uses the property as his principal residence, fulfilling the requirement that it is not a secondary or vacation home.
• Expense Deductions: Jane can deduct normal rental expenses such as mortgage interest, property taxes, maintenance, and depreciation, even though she charges slightly below market rent. These deductions are classified as passive losses.
• Passive Loss Limitations: Jane’s adjusted gross income is $95,000, allowing her to deduct up to $25,000 of rental losses against her non-passive income. Any losses exceeding this limit can be carried forward to future years.
• Documentation: Jane keeps detailed records of the fair market rent, including comparable property listings, statements from real estate agents, and an independent appraisal.

Determining Fair Market Rent

To determine fair market rent, compare rental listings for similar properties in your area based on size, condition, location, and amenities. Use online tools to estimate rent and supplement these with local data. Account for recent market changes and document your research to substantiate the rent amount if reviewed by the IRS. 

Avoiding Common Pitfalls

• Avoid providing monetary gifts to relatives to help them pay rent, as the IRS may view this as a disguised rent discount, which could result in the property being classified as personal use and loss of rental expense deductions. 
• Renting to relatives at below-market rates can be a red flag for IRS audits. Ensure that all rental agreements are conducted the same as you would if it was between unrelated parties, and that you can justify the rental amount with solid documentation.

The Taxing Tale of Renting to Family: How to Keep the IRS at Bay

Renting a home to a relative offers a means to help family members while potentially enjoying rental income benefits. However, strict adherence to IRS rules regarding fair market rent and the principal residence requirement is crucial to avoid losing valuable tax deductions. Consult a tax advisor to ensure compliance and make informed decisions when entering into rental agreements with family members. Understanding these nuances can save you from unexpected tax liabilities and help maintain a beneficial rental arrangement.

Bottom line: it is important to set the rent at a fair rate, even when renting to a relative.

By carefully considering these guidelines and consulting with tax professionals, you can navigate the complexities of renting to relatives while maximizing your tax benefits.