Charge Fair Market Rent
Renting to relatives is fraught with financial disaster unless the arrangement is structured carefully. When it comes to the IRS, no good deed goes unpunished. You decide to help your kids get a good start in life and out of your house. You buy an investment property and rent it to your child for enough to cover the payments but $200 less than fair market rent. You don’t have a lease because it is your child. You are not looking to profit from your child but don’t mind the tax breaks. Everyone wins, right? Wrong.
Pitfalls of renting to relatives
To be considered a business, the IRS expects that you have the intention to make a profit. By charging your child less than fair market rent, your profit motive on buying the property will be destroyed. The IRS will consider the property a second home. You will be able to deduct taxes and interest but you lose the following:
- Repair costs
- You lose the possibility of the loss on sale deduction
- You pay tax on the income from the property
Avoid the pitfall of renting to relatives
The arrangement should look arms length and structured like any third party arrangement.
- Have a lease. Formalize the arrangement between you and your relatives
- Establish profit motive. Charge fair market rent. Document the amount of the fair market rent. Do NOT discount the rent as a “gift”.
- Do not reduce the rent if they do repairs or upkeep. Your brother should pay the rent. You can pay him for the repairs as a separate arrangement.
- Have proof of payment. Make sure the money goes from them to you.
- Make sure the property is your relatives primary residence. If mom and dad spend most of the time in Michigan rather than the rental in Texas, the Texas property will be a vacation home.
Ways to help your children and preserve profit motive
You can give $14,000 per year per person with them paying no tax. The gift should be independent of the rental agreement. They should be able to use the money anyway they want. It is a gift after-all. In no way do you want to do anything to destroy arms length agreement that destroys the profit motive.
Conclusion on renting to relatives
Rental property is one of the best investments available to people today. It builds wealth and reduces taxes. Ensuring all arrangements are formal and arms length ensures you get the tax deductions you counted on when you bought the property.
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