Below Market Rent
Updated July 13, 2020

Below Market Rent: Tax Consequences of Renting Below Fair Market Value

Income Taxes

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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.

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 marketing 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.

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.

Real Estate Professional
Adjusted Gross Income
Treatment of Rental Loss
Yes
Any
Deduct entire loss against other forms of income.
No
Less than or equal to $100,000
Deduct up to $25,000 of rental losses against ordinary income and roll the remainder to next year under the passive activity loss rules.
No
Greater than $100,000 and less than $150,000
Maximum rental loss is $25,000 - 50% x (your income less $100,000). Roll remainder into next year under the passive activity loss rules.
No
Greater than or equal to $150,000
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 21, 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 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.

Fair Market Rental
Below Market Rental
Rental Income
Reported on Schedule E
Reported on Schedule 1
Mortgage Interest
Deducted on Schedule E
Deducted on Schedule A, subject to limitations
Property Taxes
Deducted on Schedule E
Deducted on Schedule A, subject to limitations
Other Rental Expenses
Deducted on Schedule E
Nondeductible
Eligible for 1031 Exchange
Eligible
Ineligible
 

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 2019 annual gift exclusion amount is $15,000, meaning that if any one person gifts any other one person in excess of $15,000, 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 $15,000 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 $15,000 each to that individual’s spouse.  What if that individual has children?  The same applies.  So theoretically, a married couple could transfer up to $90,000 of wealth to a family of three without having to file a gift tax return (see chart below).

Spouse A Gives
Spouse B Gives
Total
Received by Spouse C
$15,000
$15,000
$30,000
Received by Spouse D
$15,000
$15,000
$30,000
Received by Child
$15,000
$15,000
$30,000
Total
$45,000
$45,000
$90,000
 

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 Allec, CPA

Logan is a practicing CPA, Certified Student Loan Professional, and founder of Money Done Right, which he launched in July 2017. 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.

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2 Comments

Thanks for your article. It was exactly my question, and the answer seems clear. However, sometimes we want to be able to serve people in our church family that doesn’t make financial sense. Perhaps you can shed a bit more light on a specific situation. My cost to own my townhome is a mortgage of about $1300 and HOA about $400. The market value is about $2000, which our neighbor pays for the comparable unit. However, we’d like to rent it out to a church family for $1300. The question is, how would taxes work, since I’m actually taking a loss? Will I have to pay taxes on the $1300 that I’m renting out for when in fact, I’d would NOT be profiting?

From another standpoint, can I rent it out as a below market value for 2 years and then after they move out, to bring it back to at market value rental property?

Hi Stanley. Those are great questions.

As you know, in the situation you described, you would be renting your townhome at below market rent.

You would have to report your rents collected for the year on on Schedule 1, Line 21, where it will flow to page 2 of your 1040 and be taxed at your ordinary income tax rates.

In terms of deductions, you would not be able to deduct your HOA dues, but you may be able to deduct your mortgage interest (which is only a portion of your monthly payment) and property taxes on Schedule A insofar as these amounts are not limited, respectively, by the $1,000,000 / $750,000 mortgage interest limitation and / or the $10,000 limitation on the deduction for state, local, and property taxes.

So yes, it appears that you will have to pay taxes on the $1300 that you’re charging as rent when in fact, you’re not profiting (or you’re at least not cash flow positive).

However, as noted in the article, there may be some strategies you can apply to your specific situation that can give you a better tax answer with your below market rental. Since these strategies may or may not be applicable to your situation, it is recommended that you reach out to a qualified tax professional to discuss your options.

You can certainly convert your townhome to a market value rental property whenever you like. When this happens, you will report your rental income and expenses on Schedule E. However, you will not be able to recoup the deductions you previously incurred when the property was a below market rental.

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