— “Knowing what I know now, I should have bought Hawaii real estate when I was younger.” Life experiences bring wisdom. We can’t undo the past, but we can learn and apply our wisdom and prepare for the future, ..and the future of our kids.
Recently I met a couple that bought a Honolulu condo for their daughter who just graduated from college. The parents can claim all the tax deductions and the daughter can rent back at slightly favorable terms.
This seems like a great idea. It helps the daughter and adds to the parent’s real estate investment portfolio with tremendous tax benefits. The daughter would not yet be able to qualify for a mortgage on her own regardless of how much the parents help with gifting funds for a down payment.
I commend the parent’s foresight and proactive approach. After all, I expect Hawaii real estate to remain a desirable global commodity with seemingly endless demand. Long-term, values are poised to continue moving higher.
Chances are anybody waiting for prices to soften might look back from the future wishing they should have bought earlier.
See related article Wealth Creation With Real Estate
To avoid the pitfalls of renting to a relative you must follow specific tax rules. Otherwise, you could lose many tax deductions while still having to pay taxes on the rental income received.
The IRS considers your property either
a) a personal residence,
b) a vacation home, or
c) a rental property
Any personal residence primarily is for your personal use. This includes your primary home and any second home.
If you own a Hawaii vacation property or a condotel that you rent out then see our related article Personal Use Of Your Hawaii Vacation Rental – Tax Considerations
To claim the maximum tax deductions when renting to your relative, you want to ensure that the IRS considers the property a rental property, an investment to generate a profit, and not a property for your personal use.
Rental property income and expenses get reported on Schedule E of your tax return. Any losses can offset your gains and even lower your overall tax liability. See our related article Real Estate Tax Benefits to understand the tremendous tax breaks available for real estate investors owning rental properties.
To qualify your property as a rental property and claim the maximum tax deductions you need to:
1) Charge Fair-Market Rent
Any special deals that could make renting easier for your relative could inadvertently disallow many deductions. Don’t gift money to your relative so they can afford to pay you fair market rent. Gifts and or reduced rent could also trigger a gift tax. The current IRS limit for tax-free gifts is $15K.
The IRS allows you to rent to your relative at a small ‘good tenant discount.’ A slightly discounted 10% below fair-market rent is considered safe. That’s all. Don’t push your luck. You might be tempted to help your relative. But a borderline 20% discount could spell trouble and disqualify many of your tax deductions.
Check Craigslist for the current fair-market rent and keep records in your file as evidence.
Always execute a rental agreement, even with relatives. It clarifies the terms and avoids misunderstandings later. It also serves as evidence in case of an audit. Treat your rental as a business and not as a charity.
Tip: If fair-market rent is too expensive for your kid to pay, perhaps your kid could add a roommate to share the rent burden. Consider this an opportunity for your kid to become financially responsible and learn how to budget.
See related article 7 Residential Real Estate Investment Strategies
2) The Rental Property Must Be Your Relative’s Primary Residence
Your relative must live there full-time, not part-time. Otherwise, the IRS could consider the property your personal residence, your second home, or your vacation home, rather than a rental property. If your relative lives somewhere else and only rents part-time, then vacant days, just like non-fair-market rent days, count as personal-use days and disqualify many of the tax deductions.
Conclusion
Renting to your relative is a financial/business transaction. Follow the IRS rules to maintain the maximum tax deductions. With all tax matters, always check with your favorite qualified tax professional.
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