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Tax consequences of charging below-market rent

Many property owners don't realize charging family members below-market rent can have tax consequences.

Many homeowners decide to utilize their savings to invest in additional properties. This may include a vacation home, secondary home or other residences that may then be rented out for additional income.

Becoming a landlord affords you many deductions and tax benefits on your rental properties. However, you may not realize offering a rental to a relative at a below-market rate could make you ineligible for these tax breaks.

Personal residence vs. rental property
In order to understand the consequences of charging below-market rent, it's necessary to first know the tax differences between personal residences and investment properties. For a primary residence, you are able to claim the interest on any mortgage under $1 million, as well as any mortgage points you purchased. Additionally, homeowners can deduct interest from equity debts of $100,000 or less and property taxes.

However, the same is not true for additional properties you own for personal use. While you can deduct the mortgage interest on one other house – such as a vacation home that you use for at least 14 days a year – if you own multiple investment properties, such as a third vacation house, you won't be able to claim deductions as you would with your primary residence.

"If you rent out your properties, you unlock tax advantages not available to personal residences."

On the other hand, if you rent out these properties, you unlock several tax advantages not available to personal residences. Expenses related to the rental use of personal property – such as maintenance, repairs, property insurance premiums, utilities, depreciation, security services and housing association dues – can all be claimed. There is, however, one major caveat: If you rent out the property to a relative and fail to charge fair market rent, the IRS will no longer recognize the property as a rental.

Renting below market value
According to the IRS, a property is considered a personal residence if the owner or certain family members use it for personal use for 14 days or 10 percent of the days it is rented out. Additionally, if the property is rented to anyone, related or unrelated, for less than fair market rate, it will be considered a personal residence.

These situations often arise in the case of property owners who rent to their children. For example, say you purchased a condominium for your son to live in while he is in college. In order to teach your child about financial responsibility, you decide to treat him as a tenant, and he agrees to lease the apartment. However, the rent you are charging is about half what comparable properties rent for. Even though you are receiving rent payments, because the rate falls below market value, the property would be considered a personal residence. If you mistakenly claim deductions only available to rentals, you can be fined by the IRS.

As demonstrated by a recent case in Bel Air, California, it's important to reflect the true nature of the property's use on your tax return. In this situation, a husband and wife faced a significant IRS fine after declaring expenses related to a property rented by their daughter. The couple had previously rented the house to an unrelated tenant at a rate of $6,000 a month. However, when this tenant moved out, the couple leased the home to their daughter at a rate of $2,000 a month.

"Renting below market rate makes you ineligible for many tax breaks."

When filing their taxes, the homeowners claimed expenses related to the rental use of the property. While these deductions were applicable for the years the home was occupied by the unrelated tenant who paid fair market rent, the couple mistakenly continued to file the same way while renting the property at below market rate. As a result, the deductions were disallowed and the couple faced an accuracy penalty of 20 percent of the underpayment.

In the case of the Bel Air couple, who had their return filed by a tax professional, the accuracy penalty was eventually dropped. However, it's important for homeowners with rental properties to realize renting below market rate changes the status of a property, and it's imperative you file your taxes accordingly. While this may mean that you miss out on several tax breaks, misfiling can lead to an audit, and if you have knowingly misfiled, the IRS may also charge an accuracy penalty.

Avoiding tax complications
If you want to claim the rental deductions on your investment properties, be sure the rate you charge your tenants is roughly equal to comparable properties in the same area. One way to do this is to contact brokers or real estate agents for an appraisal of your property. Be sure to document these assessments to reference in the event of an audit. Additionally, if you are renting to a relative at market value, drafting a lease can provide additional legal protections and further formalizes the use of the home for rental purposes. Be sure to keep a record of the rent you received from your relative, just as you would an unrelated tenant. 

If you do choose to rent the property to a friend or relative below market value, just be sure to reflect this in your tax return. You will still be able to claim property taxes on the property, a well as your mortgage interest if the rental is your secondary property.

If you have additional questions about filing your taxes on investment properties, contact the tax services professionals at LaPorte for experienced guidance on your return.