More and more young adults are choosing to move back in with their parents. In fact, more young adults are currently living with their parents in the U.S. than at any time since 1940. While recent college grads are doing alright in gaining employment, many aren’t earning enough to pay for a home that matched their ideal standard of living. Instead of downgrading to something they can afford, many would rather crash with mom and dad until their financial outlook is better.
Out of this recurring situation though, a new real estate trend has been born. Parents, who have found themselves with a paid-off mortgage, are opting to purchase a home for their kids to live in, while paying (reduced) rent of course, while they get their feet on the ground. This way, their kiddo has an affordable, yet attractive place to live while the parents deduct expenses of their rental property on their tax return. Sounds ideal. However, many new to the rental industry don’t realize that their are special rules that apply when renting to family members. Here’s a look at some of them, taken from a recent Forbes article.
You first have to determine how the house will be classified by the IRS, in light of Section 280A. The house will be considered either a rental property, a vacation home, or a personal residence. A rental property is rented during the year and used by the owner for personal purposes less than 10% of the number of days during the tax year that the unit was rented. If a home is considered a rental property, expenses like mortgage interest, real estate taxes, homeowner association dues, utilities, and maintenance expenses can be used to offset rental income. A classification of “vacation home” is awarded when the home is a mix between rented and used by the owner for greater than the above mentioned time period. Expenses such as mortgage interest, real estate taxes, etc are allocated between rental and personal use. Rental expenses may only be deducted to the extent of rental income generated. A personal residence happens when a home is rented for fewer than 14 days a year. Mortgage interest and real estate taxes may be deducted as itemized deduction on Schedule A, and the owner is not required to report rental income. When renting to a relative, any day rented “at less than the fair rental price” is considered a personal use day. In order for a property to be considered a “rental property,” the rent must be set at fair market rates. So if parents choose to rent their new house to their child at a discounted rate, they would have to include all rental income received from their child in taxable income, but they couldn’t deduct any of the expenses, other than mortgage interest and real estate taxes. Not a great deal.
Would allowing a child to live rent-free a better option? The parents wouldn’t obviously have to claim the extra income since there isn’t any, and they could still deduct mortgage interest and real estate taxes, but the problem here is with gift tax issues. For 2016, the annual gift exclusion is $14,000, or $1,167 a month. If the fair rental value of the home is greater than that, they would be required to file a gift tax return. It appears that if parents are wanting to help their child out, they either need to clear out the basement for their darling little-ones to move into, or charge them a fair market value for renting out their investment property. It’s up to them to determine which is the more preferable scenario.
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