Beware: If you don’t collect fair market rents (FMR) on your rental properties, your tax deductions may be disallowed by the IRS.
The reason is that the Tax Code requires that deductible expenses have a business purpose AND that you have a profit motive in order to take tax deductions.
If audited by the IRS, you may have to prove that you’re collecting FMR, which is the going rate for rents of similar properties that someone unrelated to you would pay.
The following actions or inactions may appear to the IRS that you lack profit motive:
- Discounting rents to less than the going-rate without a good business purpose.
- Allowing tenants to skip rent payments without taking legal action.
- Allowing tenants (including family members) to occupy the property rent-free.
- That your primary motive appears charitable instead of for-profit. If you have a charitable purpose, perhaps you should convert to a non-profit organization.
Failing to collect FMR may result in differing tax treatments depending on whether your tenant is a relative or not.
If tenants are not related to you. Failing to collect FMR from a non-related tenant may severely limit the amount of your tax deductions and cause the limited deductions to be treated differently than an ordinary rental, resulting in much lessor tax benefits. (See our article: “Not-for-Profit” Rentals result in Bad Tax Consequences”).
If tenants are close relatives. However, the rules are even more restrictive if you rent to close relatives AND collect less than FMR. These “not-for-profit” rentals are treated as second homes and the same as if YOU were living there. That means, you deduct property taxes and only mortgage interest not limited under the second-home rules.
You wouldn’t get the normal rental deductions, such as depreciation, insurance, repairs and maintenance AND to make matters worse, you must claim ALL of the income. (See our three articles: “Audited When Renting to Close Relatives”; “Surviving Audits when Renting to Relatives”; and “Tax Court Cases Involving Renting to Relatives”).
Beware of these relatives:
- Your spouse before the divorce is final.
- An ex-spouse, if your children are minors.
- Parents and grandparents.
- Children and grandchildren.
- Brothers, sisters and in-laws married to your brothers or sisters.
Avoid renting to close family members. In addition to the loss of tax benefits, renting to close family members can damage relationships when things go wrong. Tensions may rise when you have to evict family members and relatives are more likely to expect special treatment, like discounted rent or to miss some payments, which may cause lost deductions, if you honored their requests or failed to take legal actions for back rents.
If you MUST rent to close relatives, then be sure to:
- Collect FMR.
- Keep records that prove that you’re collecting FMR.
- Retain signed rental agreements to support arms-length business transactions.
(See our article: “Surviving an Audit when Renting to a Relative”).