June, 2010 Tax Tip
Renting Your Home to a Relative? Charge Fair Rental Value!
If you are currently renting or are considering renting a home you own to a relative for long-term use as a principal residence, the following discussion should be important to you, at least from a tax standpoint.
In many cases, renting out your home or apartment will result in a tax loss for you, even if the rental income is more than your operating costs. This is because you will be entitled to a depreciation deduction for your cost of the house or apartment (except for the portion allocated to the land). If your tenant is related to you, however, special rules and limitations may apply. For these purposes “related” means spouse, child or grandchild, parent or grandparent, and siblings. Here's the tax story:
If you rent a home to a relative who (1) uses it as his or her principal residence (that is, not just as a second or vacation home) for the year, and (2) it's rented at a fair rental (not at a discount), then no limitations apply. This means you can deduct all the normal rental expenses, even if they result in a rental loss for the year. However, if you have a loss, it is considered a “passive” loss, which is subject to a different set of limitations. Generally, you can only deduct losses from rental real estate activities to the extent you have income from other passive activities, such as other rentals or other activities in which you didn’t materially participate in its operation. There is an exception to this rule that is beyond the scope of this discussion.
The problem arises if you set the rent below the fair rental value (or charge no rent – see below). In this case the use of the home by your relative will be treated as use of the home by yourself. The results will be a tax disaster.
Since this now becomes a rental property which you are treated as using personally, you would have to allocate the expenses between the personal and rental portions of the year. Even worse, since all of the rental days (those at a bargain rate to a relative) are treated as personal days, the rental portion is zero. Thus, you would have to report all of the rent you receive in your income, but none of your expenses for the home, would be deductible, other than the mortgage interest, assuming it otherwise qualifies as deductible, and property taxes. These items are deductible even for non-rental homes.)
From the above one can see the importance of charging a fair (market) rate of rent. Factors to look at 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. If a relative is permitted to live in a residence rent-free, most likely the owner will be treated as having made a gift to the relative in the amount of the fair rental value. The annual gift exclusion for 2009 and 2010 per donor to unlimited recipients is $13,000.
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