You can lose all or most of the tax deductions associated with a rental property by letting it to family or friends – depending on what rent you set. If you charge substantially below the market rental value of the property, the IRS doesn't consider this a business property anymore.
Understanding the tax implications of renting to a family member will help you decide how you want to handle this financial situation so that both of you come out with the fairest solution to your rental agreement.
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Benefits of Rental Properties
Rental properties are great investment opportunities for a variety of reasons. If you turn a profit each year, you can add that to your retirement savings. Each year you add money to your retirement account, you grow your interest. If you're already retired, you can improve your income with one or more rental properties.
If you rent a property and just break even, once the mortgage is paid off, you can sell the house and get a large sum of money – after someone else has paid the mortgage, property tax, repairs and other expenses for 10, 20 or 30 years. In essence, you got a free house to sell.
Tax Implications of Rental Properties
If you rent a property full-time and at full price, it's considered a business property. You can deduct the expenses to own and operate it from your taxes, according to IRS rules for rental properties. This can include your mortgage interest, repairs over the years, property taxes, insurance and other costs.
You will lose some benefits of homeownership, however. For example, you can pay reduced property taxes through local homestead exemptions on property if the dwelling is your primary residence. When you sell a house that you've lived in as your primary residence, you'll also receive a tax break, depending on what the laws are at the time you sell. For example, depending on what state you live in, when you sell your primary residence after having lived in it for some number of years, you don't pay any capital gains tax on the first amount of profit (which is usually hundreds of thousands of dollars).
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Renting to a Family Member Tax Implications
There are renting to a family member tax implications to consider with various scenarios. There's no tax penalty for renting to friends or family if you charge them full or near market price. Remember, there are cases where your family member can afford full-price rent and they'd be happy to rent from someone they know and trust. You will also be happy renting to a tenant you know isn't going to be a pain.
If you give your family member a "substantial" break on the rental property, however, the IRS classifies your rental property as personal, not business property. You then lose all of the tax benefits connected to a business rental property.
In some cases, this can still be a win-win. If your family member can at least pay your break-even costs to own the home, you get a "free" property for those months while they get reduced rent. Let's say fair market rent is $1,700 per month and your mortgage payment is $900 per month. Your other expenses for the year add up to $200 per month. If you rent the property to your family member for your costs ($1,100 per month), they pay your bills and spend $7,200 less in rent each year.
You might be able to give a family member a "good tenant discount" of up to 20 percent without jeopardizing your property's classification as a business property, according to the American Institute of Certified Tax Planners. However, AICTP says the 20 percent percentage is not certain and recommends limiting your rent reduction to 10 percent.
Consider Days of Use
Rental properties also can't be used as part-time personal dwellings or vacation homes if you want to claim all of your deductions. Meet with a tax professional to determine how many days per year you, friends or family can use the house rent-free before it no longer qualifies for tax deductions associated with a business rental property.