AARP calls young adults moving back in with their parents “the new normal.” Although the U.S. economy has come a long way since the financial crisis, more young adults in this country are living with their parents than at any time since 1940. Some return home after being on their own for a while, some never left at all.
Recently, I met with clients who were in just such a situation. Their adult daughter returned to the family home after college. She is employed, but her job doesn’t pay enough to afford the life she’s enjoying in her parents’ home. Rather than downgrade to something in her price range, she wanted to stay put.
Her parents had a better idea. Financially stable with a paid-off mortgage, they would purchase a home for dear daughter to live in. The daughter could rent from her parents at a reduced rate, and the parents could deduct expenses of the rental property their tax return. Win/win?
Possibly not, since special rules apply when renting property to family members.
To deduct the costs associated with a rental property, you first have to determine how the IRS will classify the property in light of Section 280A. The house may be considered a rental property, a vacation home, or a personal residence.
A rental property is rented during the year and used by the owner for personal purposes less than the greater of 14 days or 10% of the number of days during the tax year that the unit was rented at fair rental value.
If a home qualifies as a rental property, expenses including mortgage interest, real estate taxes, homeowner association dues, utilities, and maintenance expenses can be used to offset rental income. If total expenses exceed rental income, the expenses may even generate a net loss.
When a home is mixed-use, it may be rented and used by the owner for personal purposes for more than the greater of 14 days or 10% of the number of days during the tax year that the unit is rented at fair rental value.
When a vacation home is rented, expenses such as mortgage interest, real estate taxes, etc. are allocated between rental and personal use. Rental expenses may only be deducted to the extent of rental income generated by the property. In other words, they can reduce your taxable rental income to zero, but never generate a loss.
When a home is rented for fewer than 14 days during the tax year, the home is considered a personal residence. Mortgage interest and real estate taxes may be deducted as itemized deductions on Schedule A, and the owner is not required to report rental income.
When you rent a home to a relative, such as a spouse, child, grandchild, parent, grandparent, or sibling, any day rented at less than the fair rental price is considered a personal use day. To avoid having the rental days considered personal days, the property must be rented at fair market rates and be the renter’s principal residence.
The issue, in this case, is that the parents want to offer dear daughter a bargain, charging her less than fair rental value. If they go this route, they will have to allocate expenses between personal and rental expenses. All of the days the home is rented to the daughter at less than fair rental value are considered personal days, so the rental portion is zero. They would have to include all of the rental income received from their daughter in taxable income, but none of the rental expenses would be deductible, other than mortgage interest and real estate taxes, which would be deductible as itemized deductions on Schedule A.
Is Rent-Free Better?
What if these parents wanted to be really generous and allow their daughter to live in the home rent-free? The parents could still deduct mortgage interest and real estate taxes on Schedule A, but they might run into gift tax issues.
If the daughter lives in the residence rent-free, the parents could be treated as having made a gift to their daughter equal to the fair rental value of the home. For 2016, the annual gift exclusion is $14,000. If the fair rental value of the home is greater than $1,167 per month, or the parents give any other gifts to their daughter that push them over the $14,000 threshold, they would be required to file a gift tax return. In some parts of the country, this may not be an issue, but this client is located in Scottsdale, Arizona where the average one-bedroom apartment rents for $1,225 a month.
In the end, if these parents want to help their daughter out, they should charge a fair market rate of rent, determined by looking at comparable rentals in the area. That determination of fair market rate should be documented in case they are ever audited by the IRS.
Ideally, the parents should also formalize the agreement by signing a lease detailing the terms of the agreement including rent amount, when rent is due, and any other rules they want to be followed on their property. In a perfect world, renting a home to a family member would be seen as a blessing and their daughter will be respectful of the property. However, not everyone, even dear daughter, is an ideal tenant.