When it comes to transactions between household members, common family tax mistakes occur with regularity. In families, tax laws are frequently overlooked. if not outright trampled upon. The following are some commonly encountered situations and the tax ramifications associated with each.
Renting to a Relative
When a taxpayer rents a home to a relative for long-term use as a principal residence, the rental’s tax treatment depends upon whether the property is rented at fair rental value (the rental value of comparable properties in the area) or at less than the fair rental value.
Rented at Fair Rental Value
If the home is rented at a fair rental value, it’s treated as an ordinary rental reported on Schedule E. This means losses are allowed, subject to the normal passive loss limitations.
Rented at Less Than Fair Rental Value
When a home is rented at less than fair rental value, it’s treated as being used personally by the owner. This often happens when the tenant is a relative of the homeowner. The expenses associated with the home are not deductible, and no depreciation is allowed. The result is that all of the rental income is fully taxable and reported as “other income” on the 1040. If the taxpayer were able to itemize their deductions, the property taxes on the home would be deductible. This is subject to the current $10,000 cap on state and local taxes. The taxpayer might also be able to deduct the interest on the rental home by treating the home as their second home. But only up to the debt limits on a first and second home.
Possible Gift Tax Issue
Another common family tax mistake concerns gift taxes. This issue depends if the difference between the fair rental value and the rent actually charged to the tenant-relative exceeds the annual gift tax exemption. ($17,000 for 2023). If the home has more than one occupant, the amount of the difference would be prorated to each occupant. Unless there was a large difference between the fair rental value and actual rent. (This would be over $17,000 per occupant, in 2023.) Or unless other gifting was also involved. In that case, a gift tax return probably wouldn’t be needed in most cases.
Below-Market Loans
Often there are loans between family members with no interest being charged or the interest rate is below market rates. This is one of the most common family tax mistakes that we see.
A below-market loan is generally a gift or demand loan where the interest rate is less than the applicable federal rate (AFR). A “gift loan” is any below-market loan where the interest is in the nature of a gift. A “demand loan” is any loan that is payable in full at any time, at the lender’s demand. The AFR is established by the Treasury Department and posted monthly.
Example Terms and Annual AFR Percentage
| Term | AFR (Annual) Nov. 2022 |
| 3 years or less | 3.10% |
| Over 3 years but not over 9 years | 3.00% |
| Over 9 years | 2.97% |
Generally, for income tax purposes:
Borrower – Is treated as paying interest at the AFR rate in effect when the loan was made. The interest is deductible for tax purposes if it otherwise qualifies. However, if the loan amount is $100,000 or less, the amount of the forgone interest deduction cannot exceed the borrower’s net investment income for the year.
Lender – Is treated as gifting to the borrower the amount of the interest between the interest actually paid, if any, and the AFR rate. Both the interest actually paid and the forgone interest are treated as investment interest income.
Exception – The below-market loan rules do not apply to gift loans directly between individuals if the loan amount is $10,000 or less. This exception does not apply to any gift loan directly attributable to the purchase or carrying of income-producing property.
Family Tax Mistakes Regarding Home Title Transfers
Parent Transferring a Home’s Title to a Child
When an individual passes away, the fair market value (FMV) of all their assets is tallied up. If the value exceeds the lifetime estate tax exemption ($12,920,000 in 2023), then an estate tax return must be filed. This is rarely the case, given the generous amount of the exclusion. Because the FMV is used in determining the estate’s value, that same FMV, rather than the decedent’s basis, is the basis assigned to the decedent’s property that is inherited by the beneficiaries. The basis is the value from which gain orloss is measured. If the date-of-death value is higher than the decedent’s basis was, this is the step-up in basis.
If an individual gifts an asset to another person, the recipient generally receives it at the donor’s basis (no step-up in basis).
It is generally better for tax purposes to inherit an asset than to receive it as a gift.
Example: A parent owns a home worth (FMV) $350,000 that was originally purchased for $75,000. If the parent gifts the home to the child and the child sells the home for $350,000, the child will have a taxable gain of $275,000 ($350,000 − $75,000). However, if the child inherits the home, the child’s basis is the FMV at the date of the parent’s death. So in this case, if the date-of-death FMV is $350,000 and if the home is sold for $350,000, there will be no taxable gain.
Signing Over a House Title | Continuing to Live in the Home
This brings us to the issue at hand. Frequently encountered family tax mistakes include when an elderly parent signs the title of his or her home over to a child or other beneficiary and continues to reside in the home. Tax law specifies that an individual who transfers a title and retains the right to live in a home for their lifetime has established a de facto life estate. As such, when the individual dies, the home’s value is included in the decedent’s estate, and no gift tax return is applicable. As a result, the beneficiary’s basis would be the FMV at the date of the decedent’s death.
Signing Over a House Title | Moving OUT of the Home
On the other hand, if the elderly parent does not continue to reside in the home after transferring the title, no life estate has been established. As discussed earlier, the transfer becomes a gift. This means the child’s (gift recipient’s) basis would be the parent’s basis in the home at the date of the gift. In addition, if the child were to sell the home, the home gain exclusion would not apply unless the child moves into the home and meets the two-out-of-five-years use and ownership tests.
Another frequently encountered issue is when the parent simply adds the child’s name to the title, while retaining a partial interest. If the home is subsequently sold, the parent, provided they met the two-out-of-five-years use and ownership rules, would be able to exclude $250,000 of their portion of the gain. ($500,000 if the parent is married and filing a joint return).
A gift tax return would be required for the year the child’s name was included on the title, and the child’s basis would be the portion of the parent’s adjusted basis transferred to the child. As mentioned previously, the child would not be able to use the home gain exclusion unless the child occupied and owned the home for two of the five years preceding the sale. These two family tax mistakes happen with surprising regularity, but can be rectified easily once identified.
Incorrect Withholding
Often working spouses forget to coordinate with each other when they complete the Form W-4s they provide to their employers. These forms are for the purpose of determining the amount of income tax to be withheld from their wages. Sometimes this lack of communication results in a substantial under-withholding and an unpleasant surprise at tax time.
Child Files Own Tax Return Incorrectly
Frequently a child who is eligible to be claimed as a dependent by their parent(s) files their own return. A common family tax mistake is that they neglect to check the “someone can claim you” box on page 1 of 1040. So if the parent does claim the child, they should expect to see correspondence from the IRS. The child may have claimed more standard deduction than allowed. And this action could possibly deprive the parents of deductions and credits that they are otherwise entitled to. The remedy in this situation requires the child’s return to be amended.
These are not the only examples of family tax mistakes and complications that can occur in family transactions.
Contact our office before completing any family financial transaction. It is better to structure a transaction correctly in the beginning, than suffer unexpected consequences afterwards.
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