Rental real estate taxes can be tricky. Renting out a property could be a lucrative investment, but charging below market rent could lead to unintended financial consequences – particularly when it comes to taxes.

Learn how charging below market rent can negatively impact your tax situation and common practices you should consider avoiding.

3 Reasons You Shouldn’t Charge Below Market Rent

1. Disallowed Rental Expense Deductions

If you are charging below market rent, the IRS may think your rental activities are lacking profit-driven intent. This can lead to disallowed expense deductions.

According to IRS rules, for you to deduct expenses, your rental activity must be undertaken with a profit motive. Charging reduced rent will question this motive and it may be assumed that you’re not seriously attempting to generate income from the property.

2. Personal Use of Your Rental Property

The IRS also scrutinizes the personal use of rental properties. Renting to family or friends at below market rates can trigger questions about whether the rental property is being used for personal reasons rather than a business venture.

Personal use of rental property can:

• Complicate your ability to claim deductions.
• Potentially lead to the IRS taking a deep dive into your tax returns.

3. Potential State Tax Implications

In addition to federal tax consequences, charging below market rent can also negatively impact your state taxes. States often have their own rules and regulations regarding rental properties and profit motives.

Failing to meet state criteria for a business activity can result in disallowed deductions and higher state tax liabilities.

Consequences of a Taxpayer Undercharging Rent

In a situation where a taxpayer was denied expense deductions on a rental property, the Office of Tax Appeals (OTA) determined that the taxpayer had not been engaged in the rental activity with a profit motive. A key factor against the taxpayer was the minimal rent collected from tenants.

To evaluate whether the taxpayer pursued the rental activity for profit, the OTA examined nine factors outlined in the regulations:

1. Conducting the activity in a businesslike manner;
2. Possessing expertise in the business or its processes;
3. Spending significant time and effort on the business;
4. Expecting assets used in the activity to appreciate in value;
5. The taxpayer’s success in similar or other activities;
6. The taxpayer’s history of income and losses in the activity;
7. Occasional profits earned by the activity;
8. Lack of significant income or capital from other sources; and
9. The presence of personal pleasure or recreation in the activity. (Treas. Regs. §1.183-2(b))

The OTA found that two factors favored the taxpayer: their expertise as a real estate investor and their success in real estate activities. However, these were outweighed by 5 factors indicating a lack of profit motive:

1. Renting the property back to the previous owners due to personal relationships;
2. Not marketing the property, not charging fair market rent, and lacking a lease agreement with the previous owners. Notably, no action was taken when the previous owners began paying rent sporadically;
3. Not profiting from the property’s sale and receiving minimal rental income;
4. Having significant income from other sources; and
5. Although arguing that the OTA should consider potential profit from property disposition, no evidence of expected asset appreciation was provided.

This resulted in the OTA upholding the disallowance of the rental expense deduction, concluding that the rental activity was not intended for profit. (IRC §183; R&TC §17201)

Why This Matters

Clients too often run their rentals at a loss, thinking it is a tax-savvy method of lowering their taxes. This is a terrible idea for the following reasons:

1. It does not maximize wealth, and people usually lose more cash than they save in taxes.
2. The IRS may limit the deductions if fair rent is not charged. Taxpayers must attempt to run the rental with a profit motive reasonably close to fair market rent. 
3. Third parties, like banks, use tax returns for various reasons. If the rental is intentionally not run with a profit motive, there may be a lost opportunity with the third parties.
4. There could be legal exposure if the return is not a true and fair representation of actual activity. 
   
   

Have Questions?

Consulting with a tax professional can help you navigate these complexities and make informed decisions about your rental property. Contact us today to schedule a consultation.

Resources:
https://ota.ca.gov/wp-content/uploads/sites/54/2024/08/310-Schryer.pdf
https://ota.ca.gov/wp-content/uploads/sites/54/2024/08/311-Schryer-PFR.pdf