Let's say you know of a family member or friend who needs a temporary place to stay or could benefit from a reduced housing expense arrangement. Often these "friends in need" are domestic employees, aging parents or a family member struggling with financial difficulties. You may have a second home or a property you have previously leased to unrelated tenants, and perhaps you are wondering if "doing the right thing" by assisting friends/family members with reduced housing will generate a tax deduction.
These are areas we consider when assisting clients with effective tax planning strategies. However, related party arrangements are more likely to face scrutiny and skepticism by the IRS. It is prudent to proceed with caution when considering any related party transaction, such as assisting a family member or employee with affordable housing. Some of the potential pitfalls of an IRS investigation into a related party transaction are recharacterization of the rental payments, including taxable wages to an employee or disallowance of a deduction.
Similar principles apply in a business setting. Business owners may consider renting personally owned land or buildings to their businesses in order to shift expenses of personal assets and maximize business deductions. This may result in recharacterization as distribution of profits to the business owner.
Proper planning can help minimize the risks inherent in related party rental transactions. Here are some factors to consider before you rent your property:
Formal lease agreement: Any related party rental transaction should have a signed lease agreement in place. The lease agreement should include standard lease provisions, including lease term, regular payment of rent, a reasonable rental rate, and provisions for non-payment of rent by the tenant. The terms of the lease agreement should be closely followed, including taking appropriate action for non-payment of rent.
Reasonable rent: The rental rate should be consistent with the market value for similar rental properties. Take steps to gather supporting documents for your rental rate. Acceptable documentation may include a formal comparative market analysis prepared by a real estate agent or a list of other rentals in the area, including monthly rental rates. Carefully document any reasons for a rental rate that is not consistent with the market. Property condition, improvements, location, or special features could all be factors in determining a reasonable rental rate. Any rental rate found to be unreasonable could result in the undesirable consequences noted above.
Reasonable expenses: Consider only ordinary and necessary expenses for managing or maintaining the property. Avoid claiming deductions for any expense that could be deemed a personal expense. Reduce your deductions by a percentage of personal use. If your property was only rented for half the year, only deduct half of your property-related expenses. Avoid reporting any expenses that would be unreasonable in an arms-length transaction.
The tax treatment of related party transactions can become complicated quickly. However with proper planning and documentation, you should be able to enjoy the tax benefits of your rental property while also avoiding the potential tax pitfalls. For more guidance on renting to a related party, talk to your Armanino professional.
July 14, 2017
