Renting your property in a certain range will dictate two things: tenant attention and your potential profits. If you rent the property higher than the market value, you will receive more profits per tenant but you will also impede the interest of prospective tenants, which could result in high vacancy rates. On the other end, if you set the rent too low, you will receive lower profits and will also deter tenants, since they will assume something is wrong with your property. There is a middle ground price to set when renting your property, to get an idea of this happy medium, click here.
Related: How Much Can I Rent My House for?
But what if you deliberately lower the rent of your property below market value? Say, as a favor to a person you know, such as a family relative or friend? Sure, you will be pleasing that person, but in the long run, this satisfaction will be at the expense of your investment.
Why may renting your property below market value not be the best idea? Essentially, by being a landlord, you are qualified for certain tax breaks, but when you rent a property for lower than its market value, you do not receive these tax benefits.
To further elaborate, we first need to differentiate between a personal residence, vacation home, and rental property.
- Personal Residence – A home that is rented for less than 14 days during the taxable year by the owner or owner’s family members.
- Vacation Home – A property that is rented during the taxable year but it is also used by the owner for more than 14 days or 10% of the number of days during the year in which the property is rented at a fair value.
- Rental Property – A rental property is a property that is rented out for more than 14 days or 10% of the number of days during the taxable year that the property is rented at a fair value.
Now that we have clearly defined the various kinds of properties, we’ll discuss their tax differences.
- Personal Residence: You can claim mortgage interest (if it is under $1 million) and mortgage points you have bought. You can also subtract equity debt interest of $100,000 or less. All other expenses are not deductible.
- Vacation Home: Expenses are allocated between rental and personal use as long as rental expenses have been documented. You can deduct mortgage interest on one vacation home, but if you have multiple, you would not be able to as you would with your personal residence.
- Rental Property: You can receive tax benefits. Expenses associated with the rental usage of the property (repairs, housing association fees, maintenance, etc.) can be claimed.
Side note: For a complete month-on-month breakdown of expenses, check out Mashvisor.
So, why would renting your property below market value disqualify you from tax breaks? The reason is that the IRS does not recognize such properties as rental properties. Instead, the IRS classifies them as personal residences. As previously mentioned, a personal residence is a property rented by the owner or the owner’s family for less than 14 days or 10% of the number of days in the year. Also, renting your property below fair market value to a tenant, whether they are a family member or not, would still be considered a personal residence, not a rental property.
All this aside, this does not mean that renting your property below market value is illegal. It is totally legal, but, as we mentioned, you lose beneficial tax breaks if you do so. The choice is yours, but be aware of the implications on your tax returns.
Ok, so we’ve discussed why renting your property below fair market value may not be the best. Now let’s talk about what fair market value is.
The meaning of fair market value is pretty straightforward – it is the value of a property based on the market. Here are a few ways you can determine the fair market value of a property:
Perform a comparative market analysis
This shows you the prices of similar properties to yours that are on the market. You can use Mashvisor to conduct comparative market analysis on both traditional and Airbnb properties.
Related: How to Perform a Real Estate Market Analysis
Seek the help of a professional appraiser
Have a licensed appraiser examine your property. The appraiser will conduct a physical inspection of the property mainly by analyzing its condition, its construction, and any material issues that need to be addressed. The appraiser will also conduct a comparative market analysis to some extent, comparing the physical aspects of your property to others on the market.
Compute the property’s rental yield
Rental yield is a percentage of the annual income of a property divided by its cost multiplied by 100%. This is its net formula: (annual rent – annual costs / purchase cost) × 100%. By knowing your property’s rental yield, you can find out how much income you will receive by renting your property. You can also compare your property’s rental yield to that of others to get a better understanding of the market’s value. Mashvisor allows you to calculate the rental yield of a property.
Related: How to Calculate Rental Yield
To sum up, renting your property below fair market value to a relative or nonrelative will make you miss out on certain tax breaks. But, as we already mentioned, this does not make it illegal, but it can be costly in the short-term and long-run. Also, if you do decide to rent at a lower value, you can still claim mortgage interest (if the property is a second property) and property taxes.
None of this means you cannot be renting your property to a relative. If you do decide to rent out to a relative at fair rental value, try to have this mentioned in the lease to ensure no tax complications. Keep a record of rent you receive, as you would with any other tenant.
Finally, remember, positive cash-flow is priority!