Are landlords allowed to take depreciation deductions when renting property to relatives at less than fair market value, provided it does not create a loss?
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No, landlords are generally not allowed to take depreciation deductions when renting property to relatives at less than fair market value, even if the rental does not create a loss.
1. Legal Framework
1.1Profit Motive Requirement
- For rental expenses, including depreciation, to be deductible under the Internal Revenue Code, the activity must be engaged in for profit. This is required by sections 162 (trade or business expenses) and 212 (expenses for the production of income).
- If a property is rented to a relative at less than fair rental value, the IRS presumes there is no profit motive. The activity is treated as "not engaged in for profit" under section 183 (the "hobby loss" rules).
1.2. Section 183 Limitations
- Section 183(b) allows only limited deductions for activities not engaged in for profit:
- Deductions allowable without regard to profit motive (such as mortgage interest and property taxes under sections 163 and 164) are allowed in full, but only as itemized deductions.
- Other expenses (operating expenses, maintenance, utilities) are allowed only to the extent gross income from the activity exceeds the deductions in (1).
- Depreciation and similar basis-adjusting deductions are allowed only to the extent gross income exceeds the sum of (1) and (2).
1.3. Application to Below-Market Rentals to Relatives
- Renting to a relative at less than fair market value is treated as an activity not engaged in for profit, regardless of whether the rental produces a loss or not.
- The IRS and courts have consistently held that such arrangements lack the requisite profit motive, and thus section 183 applies.
1.4. Depreciation Deduction Specifically
- Depreciation is only allowed under section 183(b)(2) and (3) to the extent gross income from the activity exceeds the sum of allowable interest, taxes, and operating expenses. In practice, because the rent is below market, gross income is usually insufficient to allow any depreciation deduction.
- Even if the rental does not create a loss, the lack of a profit motive means depreciation is not allowed as a deduction against other income. It can only be used to offset income from the same activity, and only to the extent described above.
1.5. Deduction Character and Reporting
- Any deductions allowed under section 183 (including depreciation, if any is allowed) are not "above the line" deductions. They are itemized deductions, not deductions from gross income in computing adjusted gross income.
2. IRS Guidance and Revenue Rulings
- Rev. Rul. 75-14 and Rev. Rul. 76-287 both confirm that when property is rented to a relative at less than fair rental value, the activity is not engaged in for profit, and deductions (including depreciation) are limited under section 183. Depreciation is only allowed to the extent gross income from the rental exceeds interest, taxes, and operating expenses, and only as an itemized deduction.
3. Example
Suppose a landlord rents a house to a sibling for $6,000/year, while the fair market rent is $12,000/year. Expenses (interest, taxes, maintenance, depreciation) total $8,000. Even if the rent covers the expenses (i.e., no loss), the rental is not considered a profit-motivated activity. Only interest and taxes are deductible as itemized deductions; operating expenses and depreciation are only deductible to the extent the $6,000 rent exceeds the interest and taxes, which is rarely the case. In most cases, no depreciation deduction is allowed.
4. Conclusion
Depreciation deductions are not generally allowed when renting property to relatives at less than fair market value, regardless of whether the rental creates a loss. The activity is not considered engaged in for profit, and section 183 limits deductions, including depreciation, to the extent of gross income in excess of other allowable deductions. In practice, this means depreciation is almost never deductible in such situations.
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