Renting to Family Members
| Content
| Intro
Employing your children in your real estate business can be a highly effective tax and financial planning strategy. It allows you to shift income from your higher tax bracket to their lower (or nonexistent) one, while also teaching them financial responsibility and providing them with a head start on their own savings and retirement. This strategy is most effective when done correctly, with careful attention to tax laws and operational requirements.
| Recognizing Income
You must still report the rental income: Even though the rent is below FMV, the income received from the family member is still considered taxable income.
Where to report the income: The income is reported on Schedule 1, which means it will not be subject to self-employment taxes.
| Taking Deductions
This is where the most significant difference lies. When a property is classified as "personal use" because of below-FMV rental to a family member, the available deductions are severely limited.
Limited Deductions: The taxpayer generally cannot deduct any expenses in excess of the rental income received. This means they cannot show a rental loss.
Allowed Deductions (Up to Rental Income): The taxpayer can deduct expenses up to the amount of rental income. The order of deduction is important:
Tier 1: Rental portion of mortgage interest and real estate taxes. These are the only expenses that can be deducted on Schedule A if the taxpayer itemizes deductions, even if the rental income is not sufficient to cover them.
Tier 2: Other rental expenses, such as maintenance, utilities, repairs, insurance, etc., can be deducted but only to the extent that the rental income exceeds the Tier 1 deductions.
Depreciation: Depreciation is typically the last deduction taken, after all other expenses. It can only be taken up to the point where the rental income is fully offset.
Suspended Losses: Because this is treated as a not-for-profit activity, any rental expenses that exceed the rental income cannot be used to create a loss to offset other income. These disallowed expenses cannot be carried forward to future years. Unlike passive activity losses from for-profit rental activities, which can be suspended and carried forward, losses from not-for-profit rentals are simply lost. The IRS treats the excess expenses as a non-deductible personal expense.
| Circumventing the Limitations
To get a different tax result and have the rental property treated as a true "rental for profit," your client must change the circumstances of the rental arrangement to meet specific IRS requirements. The two most critical factors are:
Charge Fair Market Value (FMV) Rent: This is the most crucial factor. The rent must be at or above the going rate for comparable properties in the area. This demonstrates a profit motive. Your client should have documentation to support the FMV rate, such as rent surveys or listings of similar properties.
The Property Must be the Relative's Principal Residence: For the rental to be considered a for-profit activity, the family member must use the property as their main home for the tax year.
If these conditions are met, the income and expenses are reported on Schedule E (Form 1040), Supplemental Income and Loss, which allows for the deduction of all ordinary and necessary expenses and, potentially, a rental loss. This loss is subject to the passive activity loss rules that apply to any rental property.
