Renting to a Relative? Understand the Tax Impact

What are the tax consequences of renting a home you own to a relative?

In normal circumstances, when renting a home or apartment, you’re entitled to a depreciation deduction for your cost of the house or apartment (except for the portion allocated to the land). This may result in a tax loss for you, even if the rental income is more than your operating costs.

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.

Renting to a Relative with No Limitations

No limitations apply if you rent to a relative who:

1. Uses it as his or her principal residence for the year (not as a second home or vacation home), and
2. It’s rented at a fair rental rate (not at a discount)

You can deduct all the normal rental expenses, even if they result in a rental loss for the year.

(If you have a loss, however, it is a “passive” loss, which may be subject to a different set of limitations.)

Limitations for Renting to a Relative

The problem arises if you set the rent below the fair rental value. When the rental price is discounted below fair market value, you are considered to be using the rental property personally. You would then have to allocate the expenses between the personal and rental portions of the year.

Yet, since all of the rental days are treated as personal days when renting to a relative at a bargain rate, the rental portion is zero.

This means you would have to report all of the rent you receive in income, but none of your rental expenses for the home would be deductible.

Just as with nonrental homes, you would still be able to deduct the mortgage interest—assuming it otherwise qualifies as deductible—and property taxes.

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

Factors to look at when determining a fair rate include comparable rentals in the area and whether “side” gifts were made by you to your relative which could be reasonably interpreted to be the bargain element.