With summer soon upon us, some are thinking about renting out their second homes or even their primary homes while away for travel. Rental activities can reap tax benefits, but special rules and limits may apply if the tenant is a family member. Here’s what you need to know to avoid costly unintended tax consequences.

General Rules for Rental Expenses

Renting out a home you own can produce a tax loss even if the rental income is more than your operating costs. Potentially deductible expenses include:

• Mortgage interest,
• Real estate taxes,
• Utilities,
• Maintenance, and
• Depreciation.

The IRS imposes some limitations on the amount of expenses you can deduct. For example, limits apply if you also use the home for personal purposes. You’re considered to use a home as a residence if you use it for personal purposes during the tax year for more than the greater of:

1. 14 days, or
2. 10% of the total days you rent it to others at a fair rental price.

If the home is deemed a residence, you must allocate your expenses between the personal and rental uses, based on the number of days used for each purpose. And you can’t deduct your rental expenses in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, casualty losses and rental expenses, such as broker fees and advertising costs). So you can’t claim a loss, but you may be able to carry forward some excess rental expenses to the next year.

Rules for Relatives

Letting family members stay at your home might qualify as personal use, even if they pay rent. The IRS defines family members in this context as your spouse, siblings, half siblings, ancestors (for example, parents and grandparents) and lineal descendants (for example, children and grandchildren).

If you rent to a relative, you must take certain steps to avoid the risk of the IRS reclassifying the use from rental to personal use. Reclassification could cost you hundreds or even thousands of dollars in rental expense deductions.

Avoiding the Limit

The personal use limit on deductible rental expenses doesn’t apply if the family member 1) uses the home as their main home, and 2) pays a fair rental price. If the arrangement doesn’t satisfy these criteria, you can’t deduct any rental expenses related to your relative’s stay, and you also must report the rental income. (An exception applies if you use the home as a residence and rent it for fewer than 15 days. You still can’t deduct the rental expenses in this situation, but you needn’t report the rental income.)

Short-term rentals to family may not meet the requirements. For example, if a relative rents your home only for summer months and has a principal residence elsewhere, the property isn’t that relative’s main home.

Below-market rents also jeopardize your rental expense deductions. Be careful, too, about charging a fair market rent but then gifting the relative cash to help offset the rent. Overly generous tenant discounts to family members could attract unwanted IRS scrutiny, too.

Note: If your rental expenses are disallowed, you can still claim your mortgage interest and real estate taxes as itemized deductions, subject to the applicable limits under the tax code.

Protect Yourself

As with so many tax-related issues, documentation is critical. For example, you should have copies of listings for comparable rental properties in the area to demonstrate that your relative’s rent is fair for the market. It’s also advisable to have a formal lease, as you would with a non-relative tenant. For more-detailed information on the tax rules for rental properties, contact our Tax Team.