There are plenty of great reasons to allow your family to stay in one of your properties. Whether you are allowing relatives to stay in your vacation home, your child to stay in a home of yours near their college campus, or your elderly parents to stay in one of your nicer places, you must be weary of the tax traps that will result with all of these situations.
The problem with all three of the above scenarios is that your property will be considered a personal use property unless you structure it in a manner that proves it’s a rental property. This is true whether or not the property has been a rental in the past.
The problem with personal use property is that it will be treated like a second home. You’ll lose all sorts of great rental deductions and may even have to claim rents your family member is paying you as income on your returns. Family members staying in your property will qualify it as personal use unless it is appropriately structured. Not a great way to maximize your tax efficiency.
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What is Personal Use Property?
We should first point out that the IRS speaks in terms of “dwelling unit” when discussing personal use of property. A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. 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 are not trying to make a profit with the property and are not placing it into service as a rental. Many people have second homes, and many times these second homes qualify as personal use. While there’s nothing necessarily wrong with having personal use property, there most certainly is when you weren’t expecting it to be classified as personal use. As you’ll see in a minute, the tax deductions disappear, and you may be caught holding the bag.
The Day of Personal Use Test
Naturally, there is a test to determine whether a dwelling unit is considered a personal use property or a rental property. This test is measured in the number of days you’ve used the dwelling unit for personal use. It’s the first of two tests, the second of which we will discuss shortly.
Your property (dwelling unit) will be considered a personal use property if you use it for personal purposes more than 14 days, unless you use it less than 10% of the total days it is rented at a fair rental price. Remember, “personal purposes” also means allowing a relative or child to live in the home rent-free.
It can be confusing, so let’s break out 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 certain deductions.
On the other hand, if you stay in the vacation property for more than 15 days or your child or relatives live in your property without paying rent for more than 14 days, you will need to resort to the 10% 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 (10% of 300), and the property will still qualify as a rental. This is true even though you used it for personal purposes for more than 14 days.
To clarify, earlier I stated “less than 10% of the total days” and that was simply to make the rule easier to understand in conjunction with the 14 day rule. Technically, the rule is “no more than 10% of the rented days,” so just keep that in mind.
If the property is qualified as a second home — meaning you exceeded the limits of personal use as described above — you could be in trouble. If you have a net loss, you may not be able to deduct all of the rental expenses. Deductions such as depreciation, management fees, marketing/advertising, maintenance and repairs may all be excluded from your return.
A day of personal use is any day that the unit is used by anyone who owns an interest in the property unless that person is paying a fair market rate. Additionally, any day that family members of the individuals who own the property use the property at less than a fair market rate will be considered a day of personal use. Lastly, anyone whom you agree to rent the property to at less than a fair market rate could qualify those days as personal use (so be careful with charity cases).
To ease the pain a bit, the IRS does provide some leniency here. Basically, if you were “attempting” 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 if you are experiencing vacancies, but at the same time, don’t overdo it.
The Fair Rental Income Test
While the “number of days” test is important, another test that isn’t brightly spelled out is the “fair rental price” test. A fair rental price for your property is the amount of rent that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area.
The key is to have some form of proof of the fair rent in your area. Proof may constitute you printing off Craigslist or Zillow listing of competitors. Or you may want to have an agent run comps and provide you with a rental price range. Whatever the means, make sure you have proof and store it away for later use.
This is normally a sticking point for a lot of people. 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. While it’s certainly great to support family members, if they are dragging you down and decreasing your production and contribution to society and the economy as a whole, my vote is to steer clear of free rent.
The good news is that you can provide good tenants with monthly discounts that any normal businessperson would find acceptable. Some of my clients have pegged those discounts to be around 8-10%. So if the normal market price is $1,500, they may charge their child $1,350 to live there.
Deductions Disappear When You Have Personal Use Property
If your property is deemed to be personal use, and if your rental expenses are more than your rental income, some or all of the excess expenses cannot be used to offset income from other sources. You will likely have to report the income but may not be entitled to your full deductions.
Related: 4 Bookkeeping Best Practices to Save on Taxes (& Survive Audits!)
If you use your property as a home and you rent it less than 15 days during the year, its primary function is not considered to be rental, but instead personal use. In this case, it should not be reported on Schedule E as normal rental properties are. Instead, expenses such as home mortgage interest and property taxes are reported on Schedule A. In this situation, you won’t be required to report your income.
A fun strategy to consider is to AirBnB your primary home for 14 days while you travel. This will allow you to bring a small portion of income in that is tax-free!
If you use your property as a home and rent it 15 days or more during the year, you will have to include your rental income on your return. If you used the property for less than 14 days for personal use, 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 also rent the property for more than 15 days, you’ll have your work cut out for you. In this case, you will be dividing expenses between Schedule E and Schedule A — between your rental and personal use. Additionally, 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 $25k).
The key is to understand that your children and relatives living in your property without paying fair market rent are qualifying your property for 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.
If personal use exceeds 15 days and you rented at a fair market rate, expenses are split between Schedule A and E, which is bad. If personal use exceeds 15 days and it wasn’t rented at a fair market rate for at least 15 days, now you have a personal use property that can’t deduct the majority of the expenses that make real estate awesome.
While this may be confusing, just be sure to loop your CPA in prior to involving any friends or family in your rental business. And remember, 14 days of personal use!
Rental owners: Any questions about this concept? Anything to add to the discussion?
Leave your comments below!