ALBUQUERQUE, N.M. — Q: I am considering buying a house to rent to my daughter. She has two dogs and a cat and needs a property with a yard and currently she lives in an apartment where she has to pay extra every month for the pets. I have owned rental houses in the past so I have no concerns about being a landlord or finding a property that would be a good investment. My question is whether there are any special tax rules that apply to how I would file this on my tax return.
A: If you have had rentals in the past you know that rental income and all associated expenses are reported on IRS Schedule E. Any net income carries forward to the first page of the tax return. Any losses might be limited, generally depending on your income.
That is what happens to a “normal” rental, which is one rented to an unrelated tenant. The same reporting generally applies if the tenant is your daughter with one key potential difference.
The tax law has special reporting rules for property that is held for rental as well as for personal use. These rules are commonly called the “vacation home” rules. Two special reporting issues arise for vacation homes.
First, all expenses must be allocated between the rental use and the personal use. Items such as property taxes and mortgage interest are reported either on Schedule A (the personal portion) or Schedule E (the rental portion).
Items that are allowed as deductions only for investment property, such as insurance, maintenance, repairs, and depreciation, must also be allocated between personal and rental use. Only the rental portion may be claimed as a deduction.
Second, if the personal use of the property exceeds the greater of 14 days or 10% of the rental days, no net loss is allowed to be reported for the rental portion of the property. So (allocated) expenses are allowed, but not in excess of the rent income.
But, you say, I didn’t say there would be any personal use. This will be a rental, not a vacation home. Well, perhaps.
The issue is that any use by your daughter is treated as personal use by you unless she pays fair rental value for her use. Fair rental value should be what an unrelated tenant would pay for use of the same property.
To illustrate, let’s say that an unrelated party would pay $1,500 per month in rent, plus a damage deposit for the pets, plus utilities, plus a $75 per month charge for the pets. If you charge your daughter those exact amounts, you have no issues.
Where the issue becomes clouded is when you reduce or eliminate some of these charges. A reasonable person might then say that you are not charging fair rental value and that your daughter’s tenancy is all personal use by you, at least in the eyes of the tax law.
Another equally reasonable person might say, hold on, let’s dig a bit deeper. If you would pay a property manager to handle a credit check, lease preparation, collecting rents, and handling tenant issues, maybe you could avoid that charge because you are comfortable dealing with a daughter-tenant.
Maybe you know the pets well and do not feel that a damage deposit or an additional charge for the pets would be justified. Maybe you know that your daughter has the skills to oversee a botanical garden and will bring abundant life to that drab landscaping of yours.
A reasonable reduction in one or more charges that is justified by the factors noted above, or factors that I did not mention, may still satisfy the tax law standard of fair rental value.
Charging your daughter half the normal rent brings you into the realm of simply not reasonable. That is, a reasonable person could not argue that she is paying fair rental value, even if some or all of the above-mentioned factors applies.
Those are the rules. I do not know how they might fit your facts. If you think you can justify some reduction in charges based on some or all of the factors I mention, be sure to document your reasoning.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.