Buying an investment property is one way to generate additional income. That’s why some individuals choose investment properties as a way to set aside money — maybe for retirement or even their children’s education. In a recent poll, 35% of Americans said real estate was their preferred investment over stocks and bonds.
Hitting even closer to home, as children transition into adulthood and live independently, some owners may consider letting their children live on the property. If you’re at the point where it seems like a discussion to be had, you may be asking yourself several questions, including: Do I charge rent? How will we handle messy situations? Are there tax implications?
5 things to know about renting to family
Here are five rules to follow when renting to those closest to you, in addition to carefully considering those expenses that are required to keep your investment property in working order.
1. There is a personal use limit. If you want all the tax benefits of owning a rental property, you must limit personal use of the property. The IRS will consider the property to be your personal residence if you use it for personal purposes during the tax year for more than the greater of 14 days or 10% of the days it is rented to third parties at a fair rental price. If you decide to let your children live in the rental property for free, that would be considered personal use. And if the property is deemed a personal residence, you still have to report the rental income but cannot deduct any expenses, including mortgage interest, repairs or property taxes.
2. Hefty discounts are not wise. Charging fair market value is a must to benefit from tax deductions and breaks. You may read that it is acceptable to offer a 10% good tenant discount, but it depends on what that discount is for. According to the American Apartment Owners Association (AAOA), providing this discount in exchange for early payment may be illegal.
3. Have proof of fair rental value. It is crucial to research fair market value by checking local listings and to save that information as proof that you are charging a reasonable monthly rent. This way, if there are questions from the IRS, you have research to validate your decision.
4. Don’t offer financial help. Don’t be tempted to provide financial assistance to your children to help them pay their rent. These assistance payments are recognized as gifts by the IRS and can be deducted from the rental amount, turning the property use into personal use instead of rental use.
5. The property needs to be their primary residence. Finally, they need to live in the property as their primary residence and not as a second housing option. If your child is only planning to live in the apartment or house while at college, it needs to be their primary residence for more than 50% of the whole year. Otherwise, it isn’t considered a valid rental.
Pros of renting to family
There are drawbacks to consider when renting to relatives. However, there are also pros to renting to a family member.
- They can’t lie on their application.
- You know their personality and lifestyle.
- You can help somebody you care about.
If you consider purchasing an investment property, review the above financial implications and remember that it will likely cost you more than your traditional mortgage, so accepting a discount could be a bigger hit. Plus, always make sure you follow the IRS regulations for rental properties to take advantage of all tax deductions and breaks.
