Question about taxation of rental property income when one rental is below FMV

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Topic Author
cacophony
Posts: 1354
Joined: Tue Oct 16, 2007 9:12 pm

Question about taxation of rental property income when one rental is below FMV

Post by cacophony »

I have a question about the taxation of rental property income.

Assume somebody owns one rental property, and is about to buy a second.

The currently owned property has been owned for a very long time and has almost insignificant expenses (property tax, insurance, etc), and the new property will have very high expenses in comparison (approximately 10 times as much). The fair market rental values of the two properties are roughly equivalent.

The original property is currently rented out at fair market value, and the owner presumably pays significant taxes on that rental income.

The property owner would like to have a relative live in the newly purchased property for a couple years while charging them a very small rental amount. The amount would be significantly less than fair market value and also much less than the expenses for the new property.

In this case the combined rental income from the two properties would likely be about equivalent to the combined expenses for the two properties.

To throw some made up numbers into the situation:

Rental #1 expenses: $5k/year
Rental #1 rent: $45k/year (market rate)

Rental #2 expenses: $50k/year
Rental #2 rent: $10k/year (market rate would be $45k/year)

In this case, combined expenses = combined rent

Would this mean that no taxes would be owed on the rental income because the expenses would entirely offset them? Or is this prevented somehow? 1040 schedule E seems to imply that it all gets combined into a single rent bucket and single expenses bucket, but maybe I'm missing something.
mhalley
Posts: 10424
Joined: Tue Nov 20, 2007 5:02 am

Re: Question about taxation of rental property income when one rental is below FMV

Post by mhalley »

The irs frowns on it, but I don’t know how active they are at enforcement. This article discusses it. Apparently you can’t take the deductions for the loss as it is now considered personal use.
https://bizfluent.com/info-8617156-irs- ... vices.html
If you do not charge a family member fair market value for a rental unit he occupies as his residence, you automatically lose certain IRS deductions you would otherwise qualify for. Relatives, according to the IRS, include your sisters and brothers (including half-siblings), your parents, grandparents, children and grandchildren. Renting below market to a relative, in the IRS view, becomes a personal use. A personal use cannot qualify for a rental loss deduction (where, for example, your rental expenses exceed your rental income. This practice also disqualifies the sale of the house as a business loss, where you sell the property for an amount less than the total of what you paid for it, plus rental income and minus rental expenses. If you take a rental loss deduction or a business loss deduction, the IRS will penalize you.
Apparently you can’t charge the rent at market value then make it up by gifting either.
https://certifiedtaxcoach.org/five-tips ... relatives/
Topic Author
cacophony
Posts: 1354
Joined: Tue Oct 16, 2007 9:12 pm

Re: Question about taxation of rental property income when one rental is below FMV

Post by cacophony »

mhalley wrote: Sat Oct 16, 2021 10:49 pm The irs frowns on it, but I don’t know how active they are at enforcement. This article discusses it. Apparently you can’t take the deductions for the loss as it is now considered personal use.
https://bizfluent.com/info-8617156-irs- ... vices.html
If you do not charge a family member fair market value for a rental unit he occupies as his residence, you automatically lose certain IRS deductions you would otherwise qualify for. Relatives, according to the IRS, include your sisters and brothers (including half-siblings), your parents, grandparents, children and grandchildren. Renting below market to a relative, in the IRS view, becomes a personal use. A personal use cannot qualify for a rental loss deduction (where, for example, your rental expenses exceed your rental income. This practice also disqualifies the sale of the house as a business loss, where you sell the property for an amount less than the total of what you paid for it, plus rental income and minus rental expenses. If you take a rental loss deduction or a business loss deduction, the IRS will penalize you.
Apparently you can’t charge the rent at market value then make it up by gifting either.
https://certifiedtaxcoach.org/five-tips ... relatives/
Thanks, that's very helpful.
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