Avoid the Big Triple-Tax Whammy When 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, even children attending college, and mothers and fathers in retirement. Actually, any relative who will take good care of the property is an ideal candidate.

But you need to know how to rent to relatives, because renting incorrectly can easily earn you victim status in the tax law.

Victim Surprise

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 of additional taxable income—victim income—because you did not know how to rent to your relative.

Overview

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 accounts.

There are two types of rentals to consider when it comes to your relatives:

1.
Your relative rents a house or an apartment from you and uses it as a personal residence.

2.
Your relative rents your beach house, lake cabin, or other vacation home.

Special rules apply to both of these types of rentals.

Fair Rent Required for Personal Residence

Fair rent or else. If you are renting a home or apartment to your relative for his or her use of that property as a personal residence, you must charge fair rent to your relative, or the tax code will destroy that rental arrangement.

You absolutely do not want the tax code to destroy the rental arrangement. If destruction occurs, you immediately lose the deductions you had claimed on this property (other than mortgage interest and property taxes), such as

·
depreciation,

·
repairs and maintenance,

·
utilities,

·
lawn care, and

·
other rental expenses.

The smoldering ruins you have left after destruction of the rental arrangement are itemized deductions for mortgage interest and property taxes, and these might not give you full deduction benefits after they suffer attacks by other tax code sections.

What happened in this destruction is that the tax code made this rental an undesirable second home, and this produces an almost perfect double whammy:

1.
Say goodbye to the deductions above.

2.
Say hello to the rental income with no offsetting rental deductions.

Tax law is merciless! It taxes all income, from every source, except sources granted a specific exemption from taxation.

The Triple Whammy of the Jackson Case

Vashon Jackson got a firsthand look at these harsh results when the court turned his rental into a residence. Mr. Jackson purchased a home that he then rented to his wife’s parents for $500 a month.

The court found that the rent should have been at least $600 a month. Because of this, the court ruled that Mr. Jackson violated the fair-rent rule, and this turned his rental property into a personal residence (a second home).2

Because the property was classified as a second home, the only deductions available to Jackson were its 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, Jackson had claimed $72,898 in rental deductions.

Whammy 1 hits Mr. Jackson’s wallet with the addition of $53,321 in taxable income for his disallowed rental property deductions ($72,898 – $19,577).

Whammy 2 hits Mr. Jackson’s wallet when he has to pay taxes on the $18,000 of rental income even though the rental is no longer recognized as a rental.

Mr. Jackson takes a total hit of $71,321 ($53,321 plus $18,000) in additional taxable income because he failed to charge his in-laws a fair rent.

Whammy 3 makes Mr. Jackson suffer a third way, in addition to losing rental deductions and being taxed on the income, when he sells this second home:

·
If he sells the second home at a loss, he may not deduct any loss on sale.

·
If he sells the second home at a gain, he pays taxes on the gain.

Avoid the Triple Whammy

Don’t let the triple whammy get you! Charge a fair rent. Have proof in your files that the rent is fair. Look for outside third-party evidence. Consider some or all of the following:

·
Printing pages from craigslist.com, where similar rentals are listed

·
Snipping comparable rental ads from the want ads, grocery store postings, and similar sources

·
Obtaining fair rent letters from property managers

·
Obtaining an independent appraisal

Don’t Make Gifts

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 as Jackson did.

Planning tip 1. If you need to give money to a relative who is not subject to the kiddie tax, so that the relative can pay the rent, consider the gift and leaseback strategy for some of your business assets.

Planning tip 2. Alternatively, you could consider hiring the relative and paying a wage. The gift and leaseback strategy is better, though, because it does not trigger any payroll taxes. (Yes, you can hire your son or daughter under the age of 18 and avoid FICA and Medicare taxes, but it’s unlikely that you are renting a house or apartment to them that they use as a principal residence.)

Consider the Good-Tenant Discount

In Bindseil,the court used a good-tenant discount of 20 percent for Bindseil’s rental to his parents, but since 1983 (when this case was decided), no other court has used the 20 percent figure.

Therefore, we recommend using no more than a 10 percent good-tenant discount, which you can justify in a variety of ways, including the fact that the good tenant eliminates the need for a management company.

And, of course, if you charge a fair rent and don’t discount that rent, you don’t have to worry about the IRS using your lack of fair rent to destroy your rental arrangement.

No Ownership by 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 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 arrangement that comes from the tax law. It requires the owner-tenant to pay fair rental to the owner-landlord for the tenant’s use of the landlord’s part of the property. For example, the owner-tenant might own 40 percent and rent 60 percent 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 children buy their first homes.

For more on shared equity, see Tax Code’s Officially Designed “Rent-to-Own Your Home” Program for Investors and Renters.

Beware of Part-Year Rentals

Question. Let’s say you are charging a fair rent. What mistake can you make that will turn your rental property into a triple-whammy second home?

Answer. Rent to a relative who does not use the rental property as a 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 for three-plus years but used the condominium for only three and a half months each year.

The court noted that the parents had their principal residence in Illinois, where they owned a home, spent most of their time, and registered and voted in the presidential election, and which issued their driver’s licenses.

Because his parents did not use the condominium as their principal residence, Mr. Kotowicz lost his rental property status and incurred the wrath of the triple whammy. He suffered just as Mr. Jackson suffered.

Don’t Rent Your Vacation Home to a Relative

For the most part, you never want to rent your vacation home to a 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.8

Your relative’s use goes against your

·
14 days’ allowed use per year, and

·
10 percent of rental days allowed use.

To put it bluntly, the rental of the vacation property to your relative could, and probably does, destroy your vacation home’s rental classification.

Relatives Who Cause These Problems

For purposes of the vacation-home rental-property rules, your relatives include your

·brothers and sisters,spouse,parents and grandparents, and children 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.

Takeaways

Without question, you need to know what you are doing when you rent a home or an apartment to a relative. Make sure of five things:

1.
You charge and receive fair market rent. Fair rent basically means the rent that a reasonable landlord would charge to an unrelated third party in an arm’s-length transaction.

2.
You have proof that the rent you are charging is fair rent.

3.
Your relative uses the house, condo, or apartment as his or her principal residence.

4.
You avoid gifts in the rental relationship.

5.
You don’t make the good-tenant discount too big, and you seriously consider the more audit-proof “no discount” approach.

Don’t leave any of the five points above to chance.

As to your beach house or ski cabin that you consider a rental property, don’t rent it to your relatives even at fair rent because the tax code considers the relative’s rental as personal use by you.