Below Market Rent: Tax Consequences of Renting Below Fair Market ValuePersonal Taxes
Most people who invest in rental property do so with a profit motive, oftentimes raising the rents as high as they can in order to maximize their income.
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Renting Below Fair Market Value
But in other situations, maximizing profits may not be the ultimate motive. In these situations, a landlord may be willing to rent to a tenant at below fair market value.
This is quite common in rental arrangements between family members, such as a wealthy parent purchasing a property near their child’s university and renting below market value to them, or perhaps an adult child letting his or her aging parents live in a property they own and only covering the mortgage or utilities.
Sometimes, a landlord may even rent at below market value to a friend or even a friend of a friend.
Regardless of what the arrangement is, the IRS has very specific tax rules when it comes to renting to someone below fair market value.
Before we discuss what these rules are, let’s discuss how rental income is generally reported on the landlord’s income tax return.
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Reporting Fair Market Rentals on Taxes
The tax code is quite generous to landlords who rent out their property at fair market rent.
Such landlords may take and may even incur a rental loss that they may roll forward to future tax years or, in certain tax situations, deduct against their other forms of income.
This favorable tax treatment for such landlords results from the fact that they are viewed by the IRS as engaging in their rental activity for profit, and the IRS generally allows those who engage in some profit activity to deduct their ordinary and necessary expenses against such profit activity.
Where Fair Market Rentals Are Reported
In general, rental income is reported on a landlord’s Schedule E, Part I: Income or Loss from Rental Real Estate and Royalties.
The amount derived at the bottom of this form is then input on Schedule 1, Line 17, where it is combined with other tax items on Line 22. This Schedule 1, Line 22 amount is then input on Form 1040, Page 2, Line 6, next to where the form reads, “Add any amount from Schedule 1, Line 22.”
What Fair Market Rentals May Deduct
As can be seen on Lines 5 – 19 of Schedule E, many deductions are available to landlords.
Although a tax professional can best guide you on your specific situation, landlords may generally deduct any cash expenses they incur in generating their rental income, in addition to any depreciation and amortization related to their property. Remember, one cash outlay that is not deductible is mortgage principal payments since that is merely the repayment of a loan, not an expense.
How Fair Market Rental Losses Are Treated
What if a landlord collects $20,000 of rent during the year and incurs $30,000 of deductions on his or her rental property, thus incurring a $10,000 loss?
The tax treatment of this loss depends on if the taxpayer is a real estate professional, and if he or she is not, his or her income level. See the table below.
|Deduct entire loss against other forms of income.
|Deduct up to $25,000 of rental losses against ordinary income and roll the remainder to next year under the passive activity loss rules.
|Maximum rental loss is $25,000 - 50% x (your income less $100,000). Roll remainder into next year under the passive activity loss rules.
|Roll entire rental loss to next yea under the passive activity loss rules.
Are Fair Market Rentals Eligible for 1031 Exchange Treatment?
When it comes to fair market rentals, the tax benefits don’t stop at being able to take tax deductions.
Your rental property is also eligible for a tax-free 1031 exchange, through which you can sell your rental property and not pay any taxes on it (this year, at least) as long as you invest the proceeds in another income-producing property and meet other 1031 requirements.
Reporting Below Market Rentals on Taxes
Now, what are the tax consequences to you if you rent out your property below market value?
You may think that the IRS would reward your generosity, but unfortunately this is not the case.
In fact, the IRS simply treats this house as a personal residence. Here’s the kicker from §280A(d)(2)(C) of the tax code:
The taxpayer shall be deemed to have used a dwelling unit for personal purposes for a day if, for any such part of such day, the unit is used…by any individual (other than an employee…), unless for such day the dwelling unit is rented for a rental which, under the facts and circumstances, is fair rental.
So what are the tax implications of renting out what amounts to be a personal residence at below market rent? Read on.
Where Below Market Rentals Are Reported
In general, the rents received on a below market rent are reported on Schedule 1, Line 8z “Other Income”, where it is combined with other tax items on Line 10. This Schedule 1, Line 10 amount is then input on Form 1040, Line 8, next to where the form reads, “Other income from Schedule 1, line 10.”
What Below Market Rentals May Deduct
Mortgage interest and property taxes are reported on Schedule A, subject to all applicable limitations. This can be a particularly bad tax answer if, say, the taxpayer already pays in excess of $10,000 in state income taxes and/or property taxes on his or her primary residence, thus eliminating any deduction for property taxes paid on the below-market rental.
What about other deductions related to the property such as utilities, homeowners association dues, supplies, etc.? Formerly, these deductions were permitted as a miscellaneous itemized deductions subject to 2% of adjusted gross income insofar as they did not generate a rental loss. However, the Tax Cuts & Jobs Act eliminated this particular category of itemized deductions, so taxpayers may no longer take a deduction for these expenses on properties they rent below market value.
How Below Market Rental Losses Are Treated
No losses are permitted on below market rentals in the current year, and they are not carried forward to future years.
Below Market Rentals: Other Tax Consequences
Another tax consequence of below market rentals is that because the property is not used in a for-profit activity, it is not eligible for a 1031 like-kind exchange.
However, if it was used as the taxpayer’s primary residence for at least two of the five years preceding the date of sale, it could qualify for the primary residence exclusion under Section 121.
Tax Strategies for Below Market Rentals
If you’ve followed this article up to this point, it’s probably pretty clear to you that below market rentals aren’t exactly the cat’s pajamas when it comes to your tax return, and you could very well end up paying more in taxes charging lower rent!
Just How Bad Are Below Market Rentals?
To recap just how bad below market rentals can be for your tax return, consider the summary chart below. While you will certainly be taxed on the below market rents you collect, your ability to take deductions against your rental income is drastically reduced when compared to a fair market rental.
|Other Rental Expenses
|Eligible for 1031 Exchange
Below, I’ve provided you with a couple ideas that may allow you to treat your rental property as a fair market rental, thereby giving you Schedule E tax treatment and entitling you to all the rental deductions described under “Reporting Fair Market Rentals on Taxes” above.So what can be done? You want to help your friend or family member out by not charging them fair market rents, but you also don’t want to be stuck with a bad tax situation.
Make note that this is not tax advice, and you should certainly discuss any strategies mentioned below or on this site with a qualified tax professional before implementing them.
Strategy 1: Have Your Tenant Improve the Property in Exchange for Reduced Rent
One thing you can do is have your tenant pay you a reduced cash amount in rent every month and make up the difference with services performed such as keeping up the property or improving the property in some way.
Note that this is considered an “in-kind” rent payment, so you and your tenant must agree on what the value of these services are — and they must be reasonable, or else the IRS could disregard them — and you must report these in-kind rent payments as rental income on your tax return in addition to the cash rents received.
Strategy 2: Charge Fair Market Rent and Gift the Difference
Another strategy is to collect fair market rent from your tenant and gift them the difference between the fair market rents and the desired rent. Please note that this strategy may be challenged by the IRS as a sham, so be sure to discuss with a qualified tax professional before pursuing it.
Remember, however, that the 2022 annual gift exclusion amount is $16,000, meaning that if any one person gifts any other one person in excess of $16,000, the one giving the gift must file a Form 709 Gift Tax Return.
Note, though, that the annual gift exclusion is on a per-person basis. So if you’re married, you and your spouse could each separately gift $16,000 each to one individual and not have to file a gift tax return. And if that individual is married, you and your spouse could each separately gift $16,000 each to that individual’s spouse. What if that individual has children? The same applies. So theoretically, a married couple could transfer up to $96,000 of wealth to a family of three without having to file a gift tax return (see chart below).
|Received by Spouse C
|Received by Spouse D
|Received by Child
Strategy 3: Don’t Exceed a 20% Discount
Although this is not in the tax code, there have been some IRS rulings in which reasonable “good tenant” discounts of 10% – 20% off fair market rent have been permitted on a Schedule E rental activity.
Of course, these rulings were based on some other taxpayer’s very specific facts and circumstances and may or may not apply to your facts and circumstances.
To be safe, I recommend consulting with a tax professional to discuss your tax minimization options.
Avoid Below Market Rents if Possible
At the end of the day, you want to help someone else pay less in rent, but you should also look to your own tax situation.
In fact, the less you pay in taxes to Uncle Sam, the more opportunity you have to help others in your community.
So if you’re considering a below-market rent situation, be sure to consult with a qualified tax professional as well as perhaps a real estate attorney if you’re going to be getting fancy with your lease agreement.
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.