IRS Rules Regarding Below Fair Market Value Rent.
At some point, you might have a rental property you wish to rent for less than fair market value. This may happen when you rent to a friend, because you have an elderly tenant who can no longer pay the property's fair market rent or for some other personal reason. Exercise some caution, because you can inadvertently violate an IRS rule and disqualify your rental property deductions.
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.
This same IRS rule also applies to below-market rentals to friends and may even extend to below-market rentals to others. The IRS has no blanket ruling on below-market rentals to others -- aged tenants and others on fixed incomes, for example, who may need some assistance as fair market values rise. In one ruling, the IRS concluded that if the rental was equal to or more than 80 percent of fair value, the rental property deductions remained in force. In this instance, it concluded that the tenant would take more than ordinary care of the rental property, thus reducing rental expenses. In a later ruling, however, the IRS disallowed a similar deduction. If you have a similar situation, consult a tax professional.
In all situations where you believe that your rental to a tenant could be construed by the IRS as being below fair market value, get an appraisal from a real estate professional. To demonstrate to the IRS the validity of your appraisal, get it in writing, signed, on the Realtor's letterhead. If rents in your area later rise or fall substantially, get a new appraisal.
Charging the fair market value of a rental property does not absolutely qualify your property for rental property deductions. If rents fall drastically in your area, for example, to an extent that you lower the rent on a property substantially below your costs, and you continue this practice for more than one year, the IRS can rule that the rental is not a "for-profit" activity and disqualify your deductions. Because IRS rules in this area are complex, carefully review the relevant IRS documents, then review them with your tax adviser.