Here's my two cents based on being a landlord for 25 years.
First, the fact that you are renting to a relative is a flag in and of itself. Not a big one. But still a flag never-the-less.
I myself may have the same or similar situation as you coming my way soon. Here's how I plan to handle it both on the personal side, and the tax side of things so that I'm not audited. Basically with what you are doing, you might as well post a sign in the front yard that says "IRS! Audit me now! Please! Hurry! Quick! FAST!"
My married daughter who has an 8-month old just arrived home from another state. soon, she'll be referring to her husband as the "ex". Don't wanna get into all those details of course. Now I have three rentals and one of them is paid off in full. Once my daughter has been working for awhile and paying both rent (not to me) and childcare, she'll come to the realization that she can never make any headway towards getting her own place. I give it three months and she'll realize she's working for her landlord and the daycare provider with very little, if anything left over. At that time I'm sure she'll take me up on my offer. Here it is.
She can live in one of my rentals for up to a year without paying rent if she chooses. But knowing my daughter, she will insist on at least paying rent in the amount of the mortgage payment. (She doesn't know one of the properties I own is paid off). So at the most, I would charge her $600/mo. (That's about my lowest mortgage payment on one of the other properties). So to maintain appearances and to keep her happy (she's very independent and refuses handouts from us, her parents) I'll draw up the rental contract just as I do for any other tenant. When she pays the rent, my plan is to bank that money separately for her. (She'll need it for those "incidentals" like furniture, curtains and stuff when you buy your first house).
Meanwhile on the tax front, I will convert the property from rental to personal use. This does several things, with the main one being that it stops depreciation. What this also means is that I can not deduct what would otherwise be deductible rental expenses. However, I can still deduct property taxes. I don't have a mortgage on the property. But if I did then I could deduct mortgage interest too.
With the property converted to personal use, that makes it a second home. My only deductions are property taxes (and mortgage interest *if* I had a mortgage on it.). The property insurance is NOT deductible on a second home. But this is family, and I don't care. Family comes first. Of course, my daughter will not be aware of any of this, as she doesn't need to be.
While my daughter is living there I will treat her like I would any other tenant. (She will insist on it.) I figure that when she gets to the point of having the money to buy her own place, I can take all that "rent" money and use it to provide her "housewarming" gifts, such as curtains, furniture, or whatever she needs. I also have the option of putting it in my grand daughter's trust.
For me with the above, it's a win-win situation for all. The property itself is already in fantastic shape, so I don't see me missing out on more than a few hundred bucks of what would otherwise be deductible rental expenses. The biggest loss will be the deduction of the property insurance. But like I said, family comes first. Besides, the cash flow from the other two rentals will easily pay that insurance, any maintenance costs incurred, as well as my deductible property taxes. So while my rental income gain will be reduced for the year, it's not going to be a loss at all.
