REWARDS AND PERILS OF RENTING TO
RELATIVES
No question about it: Your
relatives can make great tenants for your rental
properties. You know a lot about your
relatives. You probably know if they will
take good care of the property.
Ideal
candidates may include children attending
college, or mothers and fathers in retirement.
Actually, any relative who will take good care of
the property is an ideal candidate.
You
need to know how to rent to relatives, since
renting incorrectly can easily earn you victim
status in the tax law. Imagine this: Your
rental income statement shows a tax loss of
$5,000, but because you did not properly
structure the rental of this property to your
son, you
- lose
the $5,000 tax-deductible loss,
- lose
$17,000 in other claimed rental
deductions on your tax return, and
- pay
tax on $10,000 of rental income you
received from your son.
This
gives you $32,000 in additional taxable income—victim
income—because you did not know how to rent
to your relative. This is bad.
If
you are going to rent property to your relatives,
you need the information in this article. Violating
the rules in this area creates huge problems for
your savings account. The trick: Don’t
violate the law. Know the rules. Then
you can relax.
There
are two types of rentals to consider when it
comes to your relatives:
- A
personal-residence rental, like a rental
house or an apartment.
- A
vacation-home rental, like a beach house
or lake cabin.
Special
rules apply to both of these rentals.
The Right Way
to Rent a Home or an Apartment to a Relative
Fair
rent or else. You must charge a fair
rent to your relative, or the tax law will make
that rental property your second home. You
absolutely do not want this to happen because if
your property is reclassified as a second home
rather than a rental, you lose the deductions you
had claimed for
- depreciation,
- repairs
and maintenance
- utilities,
- lawn
care, and
- other
rental expenses.
All
you get from this second home are the itemized
deductions for mortgage interest and property
taxes, and these might not give you full
deduction benefits after they get attacked by the
deduction limits and phase-out-rules.
The
undesirable second-home classification not only
costs you the rental deductions, but it also
makes the rental income taxable. This is an
almost perfect double whammy. First, take
away the deductions. Second, tax the
income. The tax law is merciless! It
taxes all income, from every source, except for
sources that are granted a specific exception to
taxation.
Vashon
Jackson got a first-hand look at these harsh
results when the court turned his rental into a
residence. Jackson purchased a home that he
rented to his wife’s parents for $500 a
month. The court found that the rent should
have been at least $600 a month, ruled that
Jackson had violated the fair rent rule, and
turned his rental property into a personal
residence (a second home).
As
a personal residence, the only deductions
available to Jackson were the second home’s
property taxes and mortgage interest, which
aggregated $19,577 for the three years under the
court’s scrutiny. During the three
years before the court hearing, Jackson had
claimed $72,898 in rental deductions. Whammy
#1 to Jackson’s wallet comes from the
addition of $53,321 ($72,898 minus $19,577) in
taxable income for his disallowed rental property
deductions.
Whammy
#2 comes to Jackson’s wallet when he has to
retain the $18,000 of rental income as taxable
income in his tax return.
Jackson
takes a total hit of $71,321 in additional
taxable income because he failed to charge his
parents a fair rent.
Don’t
let this happen to you! Charge a fair rent.
Have proof in your files that the rent is fair.
No
gifts. Don’t make gifts to your
parents, children, or other relatives to help
them pay their rent. For example, say you
are renting an apartment to your daughter at a
fair market rent of $600 a month. Say you
also make gifts of $200 a month to your daughter
to help her make the rent payments. Tax law
says that you are charging your daughter only
$400 a month in rent; thus, you are not charging
a fair rent and you are going to suffer like
Jackson did.
Planning
tip. If you need to get money to your
relative so that the relative can pay the rent,
consider the gift and leaseback strategy for some
of your business assets. Alternatively, you
could consider hiring the relative and paying a
wage. The gift and leaseback strategy is
better, because it does not trigger any payroll
taxes.
Rent
discount. In Bindseil, the court used a
good-tenant discount of 20% for Bindseil’s
rental to his parents, but since 1983 (when this
case was decided), no other court has used the
20% as precedent.
Therefore,
we recommend using no more than a 10% discount,
which you can justify in a variety of ways,
including the fact that the good tenant
eliminates the need for a management company.
No
ownership for the relative. If your
relative has any ownership interest in the rental
property, the rental between you and the relative
must be pursuant to a shared-equity financing
agreement to qualify as a rental property. Otherwise
the law looks at the co-owner rental, disallows
the rental, and treats the property as your
personal second home.
The
shared-equity financing agreement is a special
term that comes from the tax law, which requires
the owner-tenant to pay fair rental to the
owner-landlord for the tenant’s use of the
rental part of the property. For example,
the owner-tenant might own 40% and rent 60% of
the house from the owner-landlord.
The
shared-equity financing agreement has a variety
of handy uses. It might be exactly the
right alternative for you to help your child buy
her first home.
Loss
not deductible; gain taxable. In
addition to losing rental deductions and being
taxed on the income, having a personal residence
that is not your principal residence exposes you
to the second-home rules. When you sell a
second home, you
·
may not deduct your losses, and
·
pay taxes on your gains.
Your
strategy is simple: Make sure that your
rental is a rental.
The
residence rule. So far we have
discussed how not charging a fair rent turns your
rental property into a personal residence. You
can also turn your rental property into a
personal residency when you rent to relatives who
do not use the property as their principal
residence.
That’s
what happened to Cedric Kotowicz when he rented
his Florida condominium to his parents for a fair
rent. Unfortunately, his parents rented the
condominium for only three-and-a-half months of
the year. The court noted that the parents
had their principal residence in Illinois, where
they owned a home, spent most of their time,
registered and voted in the presidential
election, and had their drivers’ licenses.
Because
his parents did not use the condominium as their
principal residence, Kotowicz lost his rental
property. It became a second home, giving
him deductions for only property taxes and
interest. He got no deductions for
utilities, maintenance, condo fees, or
depreciation. Further, the rental income
remained taxable. He suffered just as
Jackson did.
Don’t
Rent Your Vacation Home to a Relative
For
the most part, you never want to rent your
vacation home to your relative, unless you want
to treat that vacation rental as a second home.
Regardless of what you charge, renting your
vacation home to a relative equals personal use
by you. That personal use also goes against
your 10% of rental days allowed usage. To
put it bluntly, the rental of the vacation
property to your relative could, and probably
does, destroy your rental classification.
Who Are the Relatives That
Cause These Problems?
For
purposes of the rental property rules, your
relatives include your
- brothers
and sisters,
- spouse,
- parents
and grandchildren.
In
determining whether any of these relationships
exist, you should give full effect to legal
adoptions.
The
rules that apply to the individual also apply to
the S corporation. Think of the S
corporation as a mirror that simply reflects you
as an individual for purposes of the rental rules
in this article.
Summary
Without question, you need
to know what you are doing when you rent a home
or an apartment to a relative. Make sure of
two things:
- That
you charge and receive fair market rent.
Fair rent basically means the rent that a
reasonable landlord would charge to an
unrelated third party.
- That
your relative uses the home or apartment
as his principal residence.
Combining
the rental with gifts can get you in trouble.
Discounting the rent can get you into trouble.
These are issues you need to consider when you
rent to a relative.
Don’t
leave these issues to chance. If you
currently rent to a relative, or plan to, make
certain that you document fair rent in your
files.
Information
provided by Tax Reduction Letter, Volume
14, Number 9, September 2005
|
