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When It Comes to Family and Taxes, It's Complicated

by
Bob Mason
on
11/12/2018
When It Comes to Family and Taxes, It's Complicated

There are plenty of people who say that it's a mistake to do any kind of business with family members, but despite that, plenty of people do. There are all kinds of family interactions that can lead to tax issues, but the three most common are probably renting to a relative, lending money to a relative, and transferring a home between a parent and a child. Let's take a look at the variables that can come into play in each of these situations, and what you need to know about tax law and treatment.

Renting to a Relative 

It's one thing when you have a rental beach property, and you give a family member a break to stay there for a week. But when you have a rental property that you allow a relative to use long-term, the amount that you're charging has a big impact on how you treat the property's rental income from a tax perspective. 

  • Renting at fair rental value - The easiest and most predictable situation is where you charge your relative the fair rental value - the same thing that you would charge anybody. Doing that allows you to simply report the rental income on Schedule E as you normally would. You're able to write off losses subject to the normal passive loss limitations and nothing changes from when you were renting prior to your relative's arrival.
  • Renting at less than fair rental value - This is a pretty common scenario when a relative comes to stay. Though the property may have originally been seen as a rental, it is suddenly treated exactly the same way that it would be if you chose to stay there yourself. You lose the ability to deduct any expenses associated with the property, you lose the opportunity to depreciate, and any income that you do receive needs to be reported on your 1040 as other income and is fully taxable. Property taxes can be deducted by those eligible to itemize subject to the 2017 tax reform's $10,000 cap on state and local taxes, and there's a chance that you might be able to deduct interest on the debt you're paying on the property as long as you haven't exceeded the tax code's first and second home tax limits. 

In addition to the issue of losing your tax advantage, you also may find yourself subject to a question about gift tax depending upon exactly how much of a discount your reduced rent represents. If you are renting to a single person and the difference between fair market value and what you are charging comes to more than the annual gift tax exemption of $15,000 for 2018, you run into a tax issue. If there is more than one family member in the property, then the $15,000 gets multiplied by the number of people, making the problem a more remote possibility. 

Lending Money to a Relative 

Though there are certainly instances where loans are made between family members at market rates, when those loans are made below market rate or with no interest charged, it stops being considered a loan and is generally classified as a gift or demand loan. The benchmark is the applicable federal rate, or AFR, which is set monthly by the Treasury Department. In determining whether a loan is a "gift loan" or a "demand loan", the deciding factors surround whether the decision not to charge interest is made as a gift, and whether repayment of the loan is upon the demand of the lender. 

To get an idea of what the AFR looks like, here were the rates for October 2018:

 Term   AFR (Annual) Oct. 2018  
 3 years or less  2.55%
 Over 3 years but not over 9 years     2.83% 
 Over 9 years   2.99% 

Generally, for income tax purposes: 

There are impacts to both the person borrowing the funds and the person who is lending. 

For the Borrower: when the loan is made, they are considered to be paying the AFR rate, and they can deduct any interest that they're being charged if it qualifies.  In cases where the amount of the loan is $100,000 or less, the borrower needs to compare the amount of interest deduction they are sacrificing by virtue of the lower interest rate against their net investment income.

For the Lender: the difference between the AFR interest rate and the interest amount they are charging is treated a gift. The amount that the borrower pays is added to the amount that is sacrificed and the IRS views it as investment interest income, unless the amount that's being loaned is $10,000 or less.  This is an exception that explicitly cannot be used if the amount that is being loaned as a gift can be tied directly to a property that generates income. 

Transferring Title of A Home Between Parent and Child 

There are a number of reasons and circumstances under which a parent's home is transferred to their child. The most common is when the parent dies, in which case one of the first steps that need to be taken is the calculation of the fair market value of all of the deceased's assets. The total tally then gets compared the lifetime estate tax exemption ($11,180,000 in 2018, which is about double what it was in 2017). If it amounts to more than the exemption, then the child needs to file an estate tax return.

When an inherited estate's value is being assessed, fair market value is what's used instead of the original assigned basis from the decedent. That basis is the number that is used for calculating whether there's a gain or loss from the property, and since the value of the property at the time of death is usually higher than the basis, the basis is referred to as a step-up. 

One thing that is important to note about this type of transaction is the fact that if a family member passes an asset to another family member as a gift, it is generally accounted for in terms of the donor's basis, making it better (for tax purposes) for the family member on the receiving end to be gifted an item than to receive it as an inherited item, for which there would be a step-up in basis. 

To understand exactly how this would play out in real terms, imagine a parent that owns a property that they bought for $75,000 and which now has a fair market value of $350,000. As the parent ages, they make the decision to transfer their home into their adult child's name, after which the property is sold for fair market value. The result is a taxable gain of $275,000 ($350,000 fair market value less the $75,000 basis). By contrast, if the property is left to the child as an inheritance, their basis is the $350,000 fair market value that was in place when their parent died, leaving no taxable gain when the house is sold for the same amount. 

To complicate the issue further, imagine the frequently-experienced situation in which the elderly homeowner makes the decision that they are going to transfer title to their child but stay in their property. That transfer of title while remaining in the property creates what is known as a de facto life estate and means that even if the title has been transferred the property value is counted as part of the estate after the person dies. The transfer is not applied as a gift, and no gift tax is generated. Instead, the basis is the same as in any inheritance situation - it is the fair market value at the time of the death.

There are other scenarios that occur between an aging parent and child. In some cases, the parent transfers the title to the child and then moves out. When that happens, the life estate scenario is not created, and the transfer is considered a gift. That means that the basis remains the parent's basis on when the transfer occurs, and if the child chooses to get rid of the property through a sale, then there is no need to bring the home gain exclusion into play because it only applies if the recipient decides to occupy the property and later is able to meet the requirements for the two-out-of-five ownership and use tests. 

Finally, the last scenario that is frequently experienced is when the parent remains in the house and maintains their interest in the home but adds the child to the title on the property. What this means is that as long as the parent meets the two-out-of-five use and ownership qualification, when the property is sold the parent can exclude $250,000 of their gain (or $500,000 if both parents are alive, married and filing a joint return) and the child would need to complete a gift tax return indicating the year that they were added to the title. The child's portion of the basis would be transferred to them, and the home gain exclusion couldn't be used unless they themselves met the two-to-five-year qualification. 

From this cursory review, it should be obvious that there are numerous complications that can arise as a result of transactions that families arrange out of love or loyalty. If you find yourself engaged in this type of arrangement and you need to know how it impacts your taxes, contact a financial professional to understand all of the legal ramifications.

Bob Mason, CPA writes for TaxBuzz, a tax and accounting news and advice website. Reach his office at [email protected].  

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Bob Mason

Bob Mason

Bob Mason is the founder of Coast Financial Services Inc. servicing both the Santa Cruz, and San Jose areas. Bob Mason is a skilled financial professional who is fully equipped to assist any of your accounting needs. Founding his firm in Santa Cruz, Bob understands the importance of small businesses and how they form the backbone of the area. Coast Financial Services, Inc. has been dedicated to the growth and profitability of businesses in Santa Cruz for 17 years. To learn more about Bob Mason and the rest of his team, visit their website.

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