Renting to daughter- tax considerations

[minimustache1985]

Background: My mom is a traditional, reasonably frugal retiree who saved well and currently lives in her paid off house on SS and a small pension.  She is not currently withdrawing from deferred tax vehicles like her 401(k) but is approaching the age where she will need to take RMDs.  My sister is recently divorced and recovering financially from that.  Her income while not minimum wage is pretty low, but overall a good job (particularly with the flexibility and understanding the small company has when say, her kid is sick) that she likes.

Conundrum: Mom would like to buy a condo in a better school district than sister can afford to rent in, and then rent it to her basically at what she rents now, which is about $200 under fair market for that area based on rentdata.org.  She sees having a rental and the costs that go with it as a way to reduce her tax burden once she has to take RMDs while also helping my sister.  I fully support the idea, and H and I have one rental that is cash flow positive but negative on taxes with depreciation, but it rents at market value through a property manager so this is new territory to me.  I’m unfamiliar with what she would need to do to make sure it qualifies as a rental on taxes, as there would be no benefit to her having a “second home”.

Based on my research and limited understanding, she may need to rent it at the $200 higher market and then gift my sister the $200 back since $2400 annually is under the gift limit so that she can consider it a true rental.  Does that sound right?

If anyone is familiar with how all this works any insight you have is appreciated.

[twe]

You can google it, (and I recommend you do) but tax cases generally allow renting at a discount as long as it is reasonable. 20-25% below market is what has been upheld. You can figure 10% of that is what would have been management and 10% for good tenant discount. As long as $200 is about 20-25% below market, then it should be fine. Otherwise, probably not, and gifting back the higher rent might run you into problems.

[reeshau]

Gifting her back the $200 per month might be viewed as connected.  Gifting her, you, and each of your other siblings $2,500 out of the RMD's, no strings attached, would probably be viewed as unconnected.  What choice she wants to make between those two points is hers to make, but given there is now a condo (and its depreciation) at stake, it sounds worthwhile to spend on some professional advice.

[SeattleCPA]

I think your mom can do this... and she can set the rent to whatever works.

The issue I'd see is this: If the rent is below market, the rules of Section 280A kick in... and those rules say the below market rent means it's a personal use situation and deductions get limited. (I.e., you don't get to deduct depreciation, operating expenses, etc... you may be able to deduct mortgage interest and property taxes on Schedule A subject to limitation.)

The logic of Section 280A, btw, is that you don't get extra bonus deductions for a "fake" rental situation.

[twe]

I think your mom can do this... and she can set the rent to whatever works.

Agreed. I didn't even think about giving up the tax benefits of depreciation, but that is clearly an option. Just not a tax efficient one.

[minimustache1985]

Thanks for your responses.  She is definitely going to talk to a professional before condo hunting.

Questions I wrote out so far:
1) How do I need to determine FMR?  Can I use HUD determined FMR for the area or do I need comps for comparable condos for rent? (Note:the difference between HUD and apartment complexes is significant, but there aren’t a ton of condos for rent in the area, lots of apartment complexes and larger single family homes, however a cursory CL search found no independently owned condos currently for rent which IME rent for less since they don’t have the “amenities” of on site maintenance, on site leasing office to hold packages, etc )
2)What kind of discounts can I reasonably give a tenant and what % value?  Ie good tenant discount, tenant acting as property manager coordinating maintenance and repairs, etc.
3) If I gift both of my children an equal amount annually is that still circumventing FMR or does that disconnect the gift from the rental?

Anything else she should be asking?

[Catbert]

You can google it, (and I recommend you do) but tax cases generally allow renting at a discount as long as it is reasonable. 20-25% below market is what has been upheld. You can figure 10% of that is what would have been management and 10% for good tenant discount. As long as $200 is about 20-25% below market, then it should be fine. Otherwise, probably not, and gifting back the higher rent might run you into problems.

As a practical matter the IRS isn't going to investigate everyone's FMV on rents.  Even if she some how turned up for audit they aren't very likely to do a retroactive full blown rent study to determine the exact FMV for any given year.  I figure the above is correct  - 20-25% below market wouldn't raise any red flags.

[SeattleCPA]

You can google it, (and I recommend you do) but tax cases generally allow renting at a discount as long as it is reasonable. 20-25% below market is what has been upheld. You can figure 10% of that is what would have been management and 10% for good tenant discount. As long as $200 is about 20-25% below market, then it should be fine. Otherwise, probably not, and gifting back the higher rent might run you into problems.

As a practical matter the IRS isn't going to investigate everyone's FMV on rents.  Even if she some how turned up for audit they aren't very likely to do a retroactive full blown rent study to determine the exact FMV for any given year.  I figure the above is correct  - 20-25% below market wouldn't raise any red flags.

Late to comment but I think the following adds to thread for posterity...

Agree that IRS doesn't investigate everyone on this. But real estate rental audits are easy money for IRS auditors. Simple issues to deal with. And usually terrible bookkeeping and recordkeeping by taxpayers which means taxpayer loses on audit if only because they aren't good with paperwork.

The last real estate investor audit I represented a taxpayer through, taxpayers lost all their real estate deductions basically because they set the rent below market.

Also this procedural note: If the auditor and auditor's manager don't like the rent, the next step is to go to appeals. That's not a DIY project and can easily cost thousands. If taxpayer doesn't get issues resolved there, the next step is to go to tax court. That's not a DIY project and can easily cost tens of thousands. I mention this because a particular court case may have little weight until you get to appeals or tax court.

Final remark: Zillow and Trulia make it pretty easy to spot the where some landlord underprices the rent.

[minimustache1985]

Thanks for the replies.  Figured I’d post an update- after discussion with a pro as well as her selected realtor, mom is not going to purchase it as a rental, they are going to buy it together.  Tax benefits will be negligible as both of them take the standard deduction and the interest/taxes aren’t likely to put either over.

 A factor we hadn’t considered was why I couldn’t find any comparable condos for rent in the area- most condo associations there forbid renting as a means of keeping property values up, while two family members buying and only one living there is pretty common and perfectly acceptable.