If a parent is considering buying a property for the purpose of giving the adult child a place to live, it will be viewed as a second home or investment property purchase by a lender, assuming the parent owns real estate property already. This likely means 20% to 30% will be required as a down payment, with an interest rate higher than a conventional 30-year mortgage on a homestead.
If the parent’s intention is to eventually transfer the property to the child that is living there, what will the terms be? If there is an existing mortgage on the property, how will this be handled during the transition? Is the adult child simply a renter or will they have the ability to share in the appreciation of the property? It would be advisable, similar to a co-ownership arrangement, to have a well drafted agreement in place to manage expectations, dictate the handling of expenses and maintenance costs, and to troubleshoot future potential issues.
For instance, if the adult child will be renting the property from the parent, they have now become a landlord. Rent payments, after business expenses and deductions, will need to be reported on Schedule E on the parent’s Form 1040. A security deposit might be required and should be held in escrow. Examples of expenses that can be deducted from total rental income include:
- Depreciation – allowance for exhaustion, wear and tear of property. This can begin when the rental property is placed in service. Some or all of the original acquisition cost and the cost of improvements can be recovered using Form 4562.
- Repair costs – expenses to keep the property in good working condition (but that do not add to the value of the property).
- Operating expenses – other expenses necessary for the operation of the rental property, such as the salaries of employees or fees charged by independent contractors (groundskeepers, bookkeepers, accountants, attorneys, etc.) for services provided.
Because a parent is renting to a relative, the IRS enforces specific rules to make sure the taxpayer is not taking advantage of the tax code. For example, fair market rent (what the going rental rate is in the market for a similar sized property) must be charged to the adult child. Renting at a considerably discounted rate can lead to the property being classified as a personal residence, resulting in the loss of most rental expense deductions (although the IRS typically allows a modest discount of up to 10%). Any amount discounted beyond the fair market rental rate could be considered a gift to the adult child, subject to the
filing of a gift tax return, and disqualifying the property from being considered a rental. There is also a principal residence requirement, which dictates that for the parent to claim the house as a rental property for tax purposes, the adult child must claim the property as their principal residence. If the above two rules are satisfied, normal rental expenses such as mortgage interest, property taxes, maintenance and depreciation can be deducted, although these deductions are classified as passive losses, which may be subject to passive loss limitations.
Considering the parent is now running and maintaining a business, the parent who now finds themselves a landlord should consider creating a Limited Liability Company (LLC) to own the property and to handle the business affairs of the property. From a property management perspective, this can help shield the parent from personal liability should an accident occur on the property, or some other instance that gives rise to liability. Rental property insurance should also be pursued as another layer of protection.
Renting to Relatives: 5 Tax Tips Every Homeowner Should Know