Renting to a relative looks like the easiest landlording there is. You know the tenant, the place will be looked after, and you can afford to go a little easy on the rent.
The rent you give up is the obvious cost. The one people find later is that the IRS may stop treating the house as a rental at all.
What does a family discount cost each month?
Start with the house the rental calculator opens on: $250,000, 20% down on a $200,000 loan over thirty years at 7%, $3,000 a year in property tax, $1,400 in insurance, 5% vacancy, 5% of rent for maintenance, 5% for big replacements and 8% for management. At $2,750 a month it clears $420.
Now rent it to a relative for $2,400, then $2,200. Nothing else changes.
| At $2,750 | At $2,400 | At $2,200 | |
|---|---|---|---|
| Rent | $2,750 | $2,400 | $2,200 |
| Vacancy (5%) | −$138 | −$120 | −$110 |
| Mortgage | −$1,331 | −$1,331 | −$1,331 |
| Property taxes | −$250 | −$250 | −$250 |
| Insurance | −$116 | −$116 | −$116 |
| Maintenance and big replacements (10%) | −$275 | −$240 | −$220 |
| Management (8%) | −$220 | −$192 | −$176 |
| Cash flow each month | +$420 | +$151 | −$3 |
These are example figures, not a forecast for any market.
A $350 discount costs $269 a month, not $350, because management, maintenance and the vacancy allowance are all shares of rent and shrink with it. On $57,500 of cash invested, the return drops from 8.8% a year to 3.1%. Another $200 off and the house stops paying at all.
That is the arithmetic a relative’s rent has to survive. This house rents for $2,750 and you keep $420 shows where each line comes from.
What is a fair rental price?
The IRS defines it in Publication 527: “A fair rental price for your property is generally the amount of rent that a person who isn’t related to you would be willing to pay.”
It also gives the test for failing: “The rent you charge isn’t a fair rental price if it is substantially less than the rents charged for other properties.” There is no stated percentage in the publication, and no cutoff at 90% or 80% that makes a discount automatically fine. The comparison is to what similar places in the same area actually rent for.
So the question is not whether the rent feels generous. It is whether the number you wrote on the lease is in the range the market is paying. Setting a market rent is the same work a landlord does for any tenant, and here it doubles as the evidence.
Why does a below-market rent change your taxes?
Because of how the IRS counts days. Publication 527 lists what makes a day a day of personal use of a dwelling unit, and two of the items are about rent rather than about you staying there.
| Counts as your personal use? | |
|---|---|
| A relative pays a fair rental price and the house is their main home | No |
| A relative pays less than a fair rental price | Yes |
| A relative pays a fair rental price, but the house is not their main home | Yes |
| Anyone at all pays less than a fair rental price | Yes |
The publication’s wording is that a day counts as personal use when the unit is used by “a member of your family or a member of the family of any other person who owns an interest in it, unless the family member uses the dwelling unit as their main home and pays a fair rental price,” and separately by “anyone at less than a fair rental price.” Both conditions have to hold for the exception to apply. Where a relative has more than one home, the publication says “their main home is ordinarily the one they lived in most of the time.”
Personal-use days matter because of a threshold. IRS Topic 415 says you have used the unit as a residence if your personal-use days are more than the greater of “14 days” or “10% of the total days you rent it to others at a fair rental price.” Once that happens, expenses are split between rental and personal use by days, and Publication 527 says that where rental expenses run past rental income, “some or all of the excess expenses can’t be used to offset income from other sources.” The 14-day rule on a short-term rental works that threshold through night by night.
What happens if every day is below-market?
Then every day is personal use, there are no fair-rental days to take 10% of, and the house is not a rental for tax purposes. Publication 527 covers that case too: “If you don’t rent your property to make a profit, you must still report your rental income,” and “report your not-for-profit rental income on Schedule 1 (Form 1040), line 8j.”
Income on page one, with the expenses that normally go with a rental not available in the usual way. The depreciation deduction is the big one to lose. This rental banks $5,043 a year and shows a $417 loss on paper is the whole value of that line, and a below-market family lease is a way to hand it back.
How a particular arrangement lands depends on facts a calculator cannot see, so price the rent yourself and then take the lease to a tax professional before it starts.
How do you rent to family without the problem?
Charge a fair rental price and let the help take a different shape.
- Document the market rent. Three or four comparable listings in the same area, saved with dates, before the lease starts.
- Charge that rent on a written lease, with rent actually paid and recorded, the way you would for a stranger.
- Give the help separately if you want to give it. A gift of money is a gift. A discount on rent is a tax question.
- Check whether the house is their main home, because under the rule above, fair rent alone is not enough for a relative.
Run the rent you are considering through the rental calculator at the market figure and at the family figure, and look at the gap before you decide what you can afford to give away.