Q. My son lost his house to foreclosure in 2010. My wife and I purchased a foreclosed home in Sep 2012 for him and family to live in. We are sole property owners on the deed with my son making the mortgage, utility payments, closing cost repayment with additional money for needed repairs. I made repairs and improvements on the property in 2012. When his credit is re-established, our intent is for him to refinance the mortgage balance and purchase the house.
For tax purposes, since we bought the house, is this a rental property or a second home? If it is a rental property, I am not asking fair market rent for this property. However, I want to receive tax benefits for closing costs, taxes, insurance, improvements, etc. As long as he continues payment of all financial costs, we do not consider this home a money making investment, but an investment in my son's future. Please advise.
A. Based on your statement that your son is not paying fair rental value, the home is not a rental for tax purposes. In order for a property to be a rental, with the corresponding tax treatment, it must be rented at fair rental value. Use by a family member at below market rent is considered personal use by the owner. The "vacation home" rules of Internal Revenue Code Section 280A limit the deduction of maintenance expenses and depreciation to the rental income reduced by otherwise deductible expenses (mortgage interest, property taxes and casualty losses). Don't forget to report the rental income.
You may want to be sure that your son is not paying fair rental value by determining what market rent would be for the residence and comparing that to what your son is paying on a monthly basis. The Tax Court allowed a discount from market rent in determining fair rental value to a relative on the argument that the relative was a reliable tenant which reduced the owner's potential costs. See Bindseil, TC Memo 1983-411 where the taxpayer successfully argued that a discount from third party market rent should apply for rental to a relative based on reduced costs. The vacation home expense limitations do not apply to a home rented at fair rental value to a relative who uses it for their principal residence. In that case, it would be treated as a rental for tax purposes.
Closing costs related to the purchase of the property are added to the cost basis for the purposes of calculating depreciation and gain or loss from the disposition. Similarly, improvements to the property are added to the "tax basis." If the property is ultimately sold at a gain, the gain is taxable. If a personal use residence is sold at a loss, the loss is nondeductible. If a rental property is sold to a relative at a loss, the loss is nondeductible (per Internal Revenue Code Section 267(a)).