LAURENE H. YOUNG, (B) MPM, RMP, REALTOR
Young Hawaii Homes, Inc.
2011 President, Oahu Chapter
National Association of Residential Property Managers
Q. My daughter is moving into one of my rental units. Can I charge her below market rent and will I have any problems if I do?
A. You are certainly entitled to charge whatever rent you want, or even let your daughter live for free in the unit. However, this may subject you to different tax rules than if you rented the unit for a competitive price. I am not a tax professional, so I would highly suggest that you discuss this complicated issue and your specific tax situation with someone who is qualified to advise you.
Fair market price is the price that a person not related to you would be willing to pay. Renting substantially below market to relatives (and “substantially” is not defined by the IRS), in the eyes of the IRS, becomes a personal use. A relative includes your spouse, brothers and sisters, half-brothers and half-sisters, ancestors (parents, grandparents, etc.) and lineal descendants (children, grandchildren, etc.), but this may also apply to below market rentals to friends or others. As such, you may not be able to deduct rental expenses, or depreciation, that exceed your rental income. A day of personal use is any day of the year that you rent to anyone at less than a fair rental price. If you trade a week at your rental for a week at someone else’s rental that time is also considered personal use. If you have more than 14 days of personal use a year or rent it out at below market rent for more than 10% of the time it is rented, the IRS considers that unit as your home for that period of time, and you would have to use ratios to determine how much you can deduct.
You must report all gross rental income on your tax return. In addition, you must also report the value of services that your tenant provides in lieu of rent. For instance, if your daughter pays your maintenance fee or does yard work for the rental, you must report the value as additional rent. You would then have to declare those amounts on your tax return and pay Hawaii’s general excise tax. You could then deduct the expenses on your return. Note: If you rent your unit out for 14 days or less a year, you do not have to report that income to the IRS.
Most taxpayers are allowed to take deductions for mortgage interest and property tax on their personal homes, subject to income limitations. Normally in a for-profit rental business, you are allowed to take deductions for mortgage interest, property tax, repair costs to keep the unit in good working condition that do not add value to the property, insurance and certain other operating expenses, even if it results in a rental loss for the year. You are allowed to depreciate certain improvements that add value to the property and recover some or all of those costs over a certain period of time. The IRS assumes that any rental is a “for-profit” venture and if you have losses for several years in a row because your rent is too low, they may disallow your losses.
If you are renting at below market rent to a relative who uses the unit as their primary residence, you may be limited in what you are allowed to deduct. Your deductions may only be allowed up to your rental income. You may not be able to carry over losses to the following year. You may not be able to carry over losses to your other rental properties. If you do not charge any rent, it may be considered personal use by yourself and you may not be able to deduct anything, except for possibly the mortgage interest and property taxes. Make sure that you keep good records and save all your receipts to support any deductions in case you are audited.
As I said at the beginning, this is a very complicated issue, so contact your tax professional before you decide whether or not to charge a below market rent.