If you own residential real estate, you may be considering renting it to family members. As rents continue to rise in many parts of the country, renting property at a discount may seem like a good way to help relatives in need. But these arrangements are fraught with tax perils.

A misstep can lead to the loss of significant tax deductions. Let’s take a look at the tax treatment of rentals to unrelated parties and then examine how renting to family changes the rules.

Business vs. personal

If you use real estate strictly for business purposes — that is, as a rental property — you’re entitled to deduct mortgage interest, property taxes, utilities, depreciation, maintenance and other expenses. If your expenses exceed your rental income, you can even claim a loss (subject to passive loss limitations).

However, if you use property as a personal residence and rent it out for fewer than 15 days per year, you don’t report the rental income. You also can’t deduct any expenses as rental expenses. But if you itemize, you can still claim personal deductions — to the extent allowable — for mortgage interest and property taxes.

If you use the property as a personal residence but rent it out for 15 or more days per year, it’s treated as a mixed-use property. You report the rental income, and you must allocate your expenses between the property’s personal and business uses.

The portion of mortgage interest and property taxes allocable to personal use may be claimed as itemized deductions. These expenses and others allocable to rental use are deductible as rental expenses up to the amount of rental income; in other words, they may not create a loss. Disallowed deductions may be carried forward to future years.

Family matters

When you rent property to family members, you risk losing the ability to deduct rental expenses. That’s because use by family members is considered personal use, even if your relative pays rent, unless two requirements are met:

  1. The family member uses the property as a principal residence (that is, not as a vacation home or other second home), and
  2. The family member pays fair market rent (that is, the rent isn’t discounted).

If these requirements aren’t met, you’ll still have to report the rental income (if the property is rented out for 15 or more days per year). But you won’t be able to deduct rental expenses.

To avoid losing valuable tax benefits, it’s critical to set the rent at or above fair market value and document fair market rent with comparable rental rates in the area. You should also avoid making gifts to family members to help them pay the rent. The IRS will likely view such gifts as the equivalent of discounted rent.

Know what you’re getting into

This isn’t to suggest that you should avoid helping family members with their housing expenses. Taxes, of course, aren’t the only relevant consideration here. But if you do decide to rent real estate to relatives at a discount, be sure that you understand the tax costs. Your tax advisor can be a valuable resource.

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