Renting to Your Family Members? Don’t Fall for the “Personal Use” Trap!

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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.

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Related: 7 Myths About the Real Estate Professional Tax Status, Debunked

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.

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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).

Conclusion

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!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

19 Comments

  1. Hey Brandon nice article!

    We’ve been dealing with this situation – relative in a rental – and I hope properly! We have a lease at close to FMV. Slightly under due to them being great caretakers of the house. We trade checks. We gift them an amount equal to the annual rent and they, in turn, write us a rent check. This way we give them a free place to live but can take all landlord expenses and depreciation. Of course, we have to report the income for the “rent” (we use comps that are as low as we can find) but we benefit from being able to treat it as a rental. Our tax savings outweigh the rental income. And we write off a couple trips a year to check on the place in sunny FL.

    • ” We trade checks. We gift them an amount equal to the annual rent and they, in turn, write us a rent check.”

      I’m not a CPA, but don’t think this will hold up to an audit. Clearly you are trading checks in an attempt to circumvent the tax law. You are effectively gifting your relative free rent. I think you are on very thin ice and would consult an investment tax professional before you end up in a situation with years of back taxes and disallowed deductions to repay.

  2. Curt Smith

    I hear once in a while: can I use my SD-IRA to buy a rental in some college town, then let my daughter stay there and she manages renting the other rooms? LOL…. NO!

    BTW I’ve heard a few attorneys who specialize in IRS cases talk about famous court case where the defendant jumped through entity hoops to achive some self serving action, where straight ahead would have had tax consequences. The court case ruled that if it quacks like a duck, it’s a duck, Or the wash rule, negating the hoop jumping. Meaning the IRS’s agents and attorneys are experts at figuring out such things because its mostly what they do. 🙂 From a tax filer perspective it’s always a sleeps well or not issue. I do things that might seem odd that increase my sleeps well at night re tax form strategies. Oddly this is a personalized area. LOL

    Tnx Brandon for an interesting tax topic.

    Another topic is: SD-IRA vs solo-401k, audit risk profile, loss exposure if audited, Custodian or Not, max per year that can be added…

  3. You can use the zip-code specific HUD determined fair market rent values. Go to https://www.huduser.gov/portal/datasets/fmr.html. Click on Access to Small Area FMRs. Then click on Current Small Area FMRs. Finally, click on FY2016 Hypothetical Small Area FMRs to download the spreadsheet.

    “…in one of your nicer places, …” this kind of language always rankles because it implies the existence of a “tenant class” that does not deserve a nice home. Perhaps some tenants do not deserve a nice home, but that is what screening is for.

    • Brandon Hall

      Sorry Katie, I’m not running a charity and I’m sure nearly every other business owner intent on making a profit would agree.

      The only thing anyone ever “deserves” is what they earn. So yes, there is a tenant class that does not deserve a nice home as they don’t have the means to compensate the landlord for such a home. I don’t feel guilty for valuing captialism.

      And let’s be real, we’re talking about your relatives – you would put mom or dad in one of your C class properties even though you have an A class property in the same general area? Right…

      What “rankles” me is that you seem to enjoy trolling the BP authors. I mean, you didn’t even make it past the first paragraph of my 1,500 word article.

      Cheers.

      • Clearly I made it past the first paragraph in order to provide a source for addressing fair market rent. On the one hand, I am sorry you consider speaking out against disdain for the people who provide your profit as “trolling.” I did not realize that BP was expected to be such an echo chamber. On the other hand, I am gratified you remember some of my comments.

        All I have ever promoted was the Golden Rule, wherein we never forget what it was like to be a great tenant suffering the disdain of being automatically relegated to the “tenant class.” Some of my landlord colleagues even say things like, “Tenants rent because they are too financially irresponsible to buy,” or “Tenants could buy if they did not drink the money the could be using for a down payment,” and many other equally offensive and unsupportable statements. They say these things in a town where even four times the US median income is not enough to afford a local median house.

        If you have screened properly and thus have signed a rental agreement with a good tenant, the fair market rent that tenant is paying earns them a nice place to call home. Nice does not mean high end. It means a standard quality home with an attractive appearance, sturdy good quality everything and no deferred maintenance. That is what tenants deserve for their rent. That is what they are paying for. So often tenants get far less than they deserve. Valuing capitalism is beside the point.

        70% of the residents in my downtown area are renters. You would be amazed at the garbage even professionals must pay exorbitant rent for just to get a roof over their heads in a market with 0.5% vacancy. Deserving is a two-edged sword. If a business owner makes his profit by charging fair market rent for a substandard house, then the one who did not deserve or earn his profit is that business owner. Charity has nothing to do with it.

        • Brandon Hall

          Sorry again Katie, but you’re off your mark. Perhaps you should learn the definition of internet trolling prior to continuing to post online.

          I’ve seen you purport the Golden Rule in all of your comments, and unfortunately you have the incorrect definition of the Golden Rule. The Golden Rule means to exchange value for an equal amount of value. Nothing more, nothing less. If I provide value for less than the value I’m receiving in return, I’m engaging in charity. If charity makes me feel good, then I receive value (feeling good). Even in your own definition of the Golden Rule, the root of the definition lies within the fact that equal value is being exchanged.

          I’m not sure why you would bring up what your landlord colleagues would say unless you were trying to somehow further a weak argument. Unfortunately, it doesn’t work and has no effect on me. I’ve not said such things and I’d expect you to avoid using cheap tactics in your unfounded arguments.

          It’s funny that you continue to talk about tenants not getting what they deserve. I’m not sure how you operate, Katie, but I don’t hold a gun to a prospect’s head and force them to sign a lease. In fact, my leases are mutually agreed upon, therefore mutually beneficial (the Golden Rule). I’d assume that most landlords enter into mutual agreements as well.

          Do you force your prospect’s to sign leases? If so, then your argument has water. Otherwise, it’s laughable.

        • Unfortunately, you have an incorrect definition of the Golden Rule. It is not primarily a monetary rule (as you well know, regardless of your efforts to recast it as a monetary rule). What I said was, “Nice does not mean high end. It means a standard quality home with an attractive appearance, sturdy good quality everything and no deferred maintenance. That is what tenants deserve for their rent. That is what they are paying for. ” Even if you consider it a monetary rule, you did not actually address that point unless you mean to imply your business model means giving tenants less value than they pay for in the name of profit and capitalism.

          The whole “gun to the head” argument is a red herring used by many landlords to justify giving tenants less than what they paid for. “Mutually agreed upon” is often the wrong description. “Accepted reluctantly” is often closer to the tenant’s view of the agreement. Landlords like to forget that housing is inelastic. People NEED housing. Choice is not entirely free. If it were, we would not have the current situation where nationally half of renters are cost-burdened (paying more than 30% of their income for rent), and half of those are paying more than 50% of their income for rent.

          If my quotes reflecting landlord disdain of tenants does characterize you, good. The point of course is that tenant disdain actually does characterize a lot of landlords. This is a problem that Joshua and Brandon are addressing every time they talk about ways landlords can overcome their bad rap.

          Landlords are fond of saying that tenants should be grateful. Gratitude goes both ways. Landlords should be grateful to the tenants who are helping them build their wealth, and whose money they are often using when they talk about using other people’s money to pay mortgages.

        • Brandon Hall

          That’s pretty short sighted of you, Katie, to think that “value” can only be described in monetary terms. Did I say value is limited to monetary instruments? I don’t believe so.

          In case you missed it (you seem to have a penchant for skimming articles/comments) I’ll repost what I said:

          “The Golden Rule means to exchange value for an equal amount of value. Nothing more, nothing less. If I provide value for less than the value I’m receiving in return, I’m engaging in charity. ”

          I’m not sure what investor groups you hang out with, but everyone I know is in the game to provide value and receive value. My tenants had many options, yet chose my units. I’m currently a tenant and have a plethora of options being in DC, and I don’t feel that I’m getting screwed by my landlord at all.

          No one is holding a gun to anyone’s head. There are bad landlords out there and like bad businesses, they will eventually fail. There are also bad tenants. There are also lazy tenants who refuse to perform due diligence on their landlords yet love to complain about it later. But all of the agreements they are entering into are mutually and freely signed. No side is forcing the other to sign. That’s called capitalism.

          Because you refuse to thoroughly read articles/comments, apply critical thinking skills, and understand the definition/concept of internet trolling, I’ll no longer entertain your comments. Unless of course you’d actually like to speak about the topic of this article.

          Cheers!

        • It seems you are the one doing the skimming. You have consistently put the discussion in monetary terms, and in fact, recast the Golden Rule as exchange of equal value. You did concede that one measure of that value might be “feeling good.” The foundation of the Golden Rule between landlords and tenants is mutual respect and gratitude. In addition to monetary value, many landlords do expect to receive respect and gratitude from tenants, but do not expect to give it. In fact, landlords on BP have explicitly stated (and I am sure you have seen some of those comments). that respect and gratitude is a one-way street.

          You have also consistently avoided my main points, choosing red herrings, strawmen and ad hominem instead. If landlords indeed provide good quality rentals with no deferred maintenance at fair market rent, those landlords will likely have mutually agreed upon rental agreements instead of agreements reluctantly accepted by tenants. You are fortunate that the DC market is competitive enough that tenants can refuse substandard units. As I stated, with 70% of residents renting and a 0.5% vacancy rate, there is zero competition in my community.

          To rephrase your repost, “If I provide less value than the value I’m receiving in return, I’m engaging in (what would you call it?) ” Many would and do call that capitalism.

          I am thrilled that you recommended that tenants vet landlords. Some landlords on BP and other forums indicate they would not want a tenant who was so ungrateful and arrogant as to think they have any right to vet landlords.

  4. Deanna Opgenort

    You are presuming that Brandon’s “less nice” homes are in some way substandard rentals; to compare properties and say that one property is “nicer” does NOT mean that the others aren’t also perfectly fine properties.
    I live in a house that is nice ($600k FMV – this is SoCal, so this is a middle-class home). My cousin is very successful and lives in a house that is “nicer” (about $1million nicer). Am I somehow being treated shamefully because I’m living in a “less nice” house than my cousin?

    • I already defined what I meant by nice. “Nice does not mean high end. It means a standard quality home with an attractive appearance, sturdy good quality everything and no deferred maintenance.” FMV is not a measure of niceness, and often beside the point. As you imply, your $600K SoCal middle class home could be just as nice as a $300K Midwest middle class home.

  5. Evan Bridges

    Hello- my wife and I are on the receiving end of my family’s recently purchased second property. We do pay rent, though it is considerably less than what this home would likely rent for. As a considerate tenant and son, I would like for my family to benefit from all the tax perks of owning rental property, but at the same time we enjoy paying less rent than average. This is the first rental property they have owned and may not know of tax benefits (links to articles discussing these perks would be a great read for this newbie as well!).

    I’ve been recently diving into the BP community to seek out real estate investing information and am looking for ways to develop my own income from rental property. Any tips for using this situation as a way to launch would be appreciated!

    Thanks,
    Evan

    • Brandon Hall

      Thanks for reading Evan. If you are paying substantially below market rents, and the IRS can prove this, then the majority of tax deductions may be disallowed to your parents. I’d suggest being compensated in some other way, like mowing, repairs/maintenance, etc to help justify the lower rents. Though that could also set off a whole new chain of IRS rules to follow.

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