Below-Market Rent to Family: IRS Rules for a Two-Unit Property

Here’s a situation I saw more than once when I managed residential property. A landlord owns a two-unit building. The upstairs is rented to his daughter for $600 a month. Fair market rent for that unit is $1,100. The downstairs is rented to a stranger for $1,100. He asked me: can I still deduct the expenses for the upstairs unit?

The short answer is yes, but only up to the rent you actually collect from your family member. No loss, no carryforward. The IRS treats a below-market rental to a family member as personal use, not rental use.

The personal-use rule for family rentals

When you rent any home to a family member for less than fair market rent, the days that unit is occupied by that relative are personal-use days. That means two things. First, the rent you receive is still taxable income. Second, you can deduct rental expenses only up to the amount of that rental income. If your expenses for that unit are higher than the rent, you cannot deduct the excess. That excess doesn't become a loss you can carry to next year, and it doesn't offset income from the other unit.

I'll give you a real example. A client of mine rented a cottage behind her house to her son for $500 a month. Fair market rent was $900. Her monthly expenses for the cottage—utilities, insurance, repairs, a share of property tax—came to $700. She reported the $500 as rental income on Schedule E and deducted $500 of expenses. The extra $200 in expenses simply vanished. No deduction, no carryover.

The market-rate unit stays normal

The other unit in your two-unit building is a different story. If you rent it at fair market rent to an unrelated tenant, that unit is a normal rental property. You report the full rent as income. You deduct all ordinary and necessary expenses: mortgage interest, property taxes, insurance, repairs, advertising, and utilities you pay. You also get to depreciate that unit's share of the building basis over 27.5 years.

Keep good records to split expenses between the two units. Everything that is directly for one unit goes to that unit. Shared expenses like a roof or common-area electric get allocated by square footage or some reasonable method. The IRS expects a consistent, logical allocation.

How to avoid the expense cap

The cleanest way around the personal-use cap is to charge fair market rent to your family member. Then the unit is a rental, and you can deduct all its expenses, including depreciation. If you want to help your relative financially, give them a cash gift each month to cover part of the rent. Gifts aren't taxable to the recipient, and the annual gift exclusion is high enough for most situations. That keeps the rental at arm's length.

Another route is to document a legitimate business reason for a smaller discount. For example, if your family member performs services for the property—like managing the other unit, doing maintenance, or handling tenant calls—you can pay them for that work and charge full rent. That's cleaner than a below-market lease. But don't invent a job that doesn't exist. The IRS has seen that one before.

A final note for a two-unit property: the below-market family unit might mean you cannot claim the home office deduction or certain other tax breaks tied to rental use of that unit. The market-rate unit still gets all the normal rental treatment. If you have a mortgage on the building, interest on the family unit is still deductible as personal mortgage interest on Schedule A if you itemize, but that's a personal deduction, not a rental one.

I'm not a tax professional, and the rules around family rentals have gotten stricter over the years. If you're in this situation, sit down with a tax preparer who works with landlords. Show them the lease, the rent you charge, and the fair market rent for each unit. That conversation is cheaper than a disallowed deduction.