There are plenty of great reasons to consider renting to family. Perhaps you’re inviting relatives to stay in your vacation home, allowing your child to stay in a home of yours near their college, or moving your elderly parents into one of your nicer properties.
No matter the reason, you must be weary of the “personal use” tax trap.
What’s the problem with all three of the above scenarios? Unless you prove your property is a rental, the IRS considers these situations “personal use”—even if the property has been a rental in the past.
Personal use property is treated like a second home. You lose rental deductions—but may still have to claim rents your family member pays you as income on your returns. Not a great way to maximize your tax efficiency.
But by properly structuring your properties, you can rent to your family risk-free.
What Is Personal-Use Property?
Let’s start by defining the term “dwelling unit,” because it’s how the IRS divides property. A dwelling unit could be a:
- Mobile home
- Vacation home
However, it does not include property used solely as a hotel, motel, inn, or something similar.
Personal use of a dwelling unit simply means that you are using the property for your personal needs. You’re not making a profit by renting it out. Generally, second homes qualify as personal use.
There’s nothing wrong with personal use property. There is something wrong when a property you believed to be a rental is categorized as personal use. Then, the tax deductions disappear—and you may be caught holding the bag.
The Days of Personal Use Test
The IRS uses the “days of personal use” test to determine if a dwelling unit is a personal-use property or a rental. It’s simple, for the most part: Did you use the property for personal purposes for more than 14 days in the year? If yes, it’s a personal-use property… unless you use it less than 10 percent of the total days it is rented at a fair price.
Here’s the kicker: If family members live there rent-free, that counts as personal use. That’s because a day of personal use is any day that the unit is used by anyone who owns an interest in the property or their family members—unless they pay a fair market rate. Lastly, anyone who rents the property below-market could create a personal-use situation. Be careful with charity cases.
Here are some examples.
First, let’s say you have a vacation home and you stay in it for two weeks—14 days—during the year. It will be considered a rental property, and you won’t have to worry about losing any deductions.
The 10% test
However, if you stay in the vacation property for more than 15 days or your child or relatives live there without paying rent for more than 14 days, you will need to resort to the 10 percent test. In that case—assuming the property was rented at a fair market rate for 300 days—you can use the property for personal purposes for 30 days, or 10 percent of 300, and the property will still qualify as a rental.
An accidental personal-use property can be trouble. If you have a net loss, you may not be able to deduct all of the rental expenses. And deductions such as depreciation, management fees, marketing, maintenance, and repairs may all be excluded from your return.
To ease the pain a bit, the IRS does provide some leniency. If you attempt to rent the property at a fair market rate, those days will count as rental days, not personal use days. So don’t sweat it too much if you’re experiencing vacancies.
The Fair Rental Income Test
So what is a fair rental income? In short, it’s the average market rent for comparable properties. If you’re charging substantially less than other similar properties, the IRS will count those rental days as “personal use.”
Make sure to have proof of fair rent in your area, such as a print-off from Craigslist or Zillow. You can also have an agent run comps and provide you with a rental price range.
Unfortunately, to prevent your taxes from getting muddied, you’ll have to charge your family rent.
This can be a sticking point—for good reason. Who wants to charge their child or parent rent? Aren’t you supposed to be supportive and caring? When money is on the line, decisions must be weighed carefully. It’s wonderful to support family members, but if that generosity could severely hurt your business, a fair pricing model must be considered.
But a “fair pricing model” doesn’t preclude a discount. In the IRS’s eyes, you can provide good tenants with monthly discounts that any normal businessperson would find acceptable—around 8 to 10 percent seems to be permissible. So if the normal market price is $1,500, you can charge their child $1,350.
Personal-Use Property and Tax Deductions
With traditional rental properties, your excess expenses—or any rental costs that exceed your rental income—can offset income from other sources. That’s not always the case with personal use properties. In these cases, you will likely have to report the income but may not be entitled to your full deductions.
Let’s break this down.
Income from personal use properties rented for less than 15 days isn’t reported on Schedule E, like normal rental properties. Instead, your expenses—like mortgage interest and property taxes—are reported on Schedule A. You will not have to report your income on your tax return.
If you use your property as a home and rent it for more than 15 days during the year, you will have to include your rental income on your tax return. If you used the property for less than 14 days, you’ll report the rental on Schedule E, just like any other rental.
However, in the event that you use the property for more than 15 days for personal use and you rent the property for more than 15 days, you’ll have your work cut out for you. In this case, you divide expenses between Schedule E and Schedule A—between your rental and personal use.
Additionally, in this scenario, your rental expenses cannot exceed your rental income. Any excess loss is carried forward into future years regardless of the passive activity rules, which allow most landlords to deduct up to $25,000.
So, Is Renting to Family Members a Bad Idea?
Not necessarily! It’s all about your own personal business strategy. Just make sure you understand that when relatives live in your property without paying fair market rent, it’s personal use. This means that you will have to apply all sorts of IRS tests to determine whether or not you can deduct your expenses.
While this may be confusing, just be sure to loop your CPA in prior to involving any friends or family in your rental business.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
Rental owners: Any questions about this concept? Anything to add to the discussion?
Leave your comments below!