Converting a rental property to a second home. Family member (mother) is living in this property full time

[chag2020]

I own a townhouse and my mother lives in it.  She is paying me rent equivalent to all expenses related to the property including principal, interest, taxes and insurance and HOA.  I have no net expenses and the property is being paid off at the same time.  The monthly rental amount from my mother turns out to be equivalent to the fair market value in the area. 

1)  From IRS pub 527 I understand that this is considered a regular rental property where I report the rent as income and I make deductions and take a depreciation, all reported on schedule E.  Could you please confirm?  

2)  Would it be possible to convert this property into a second home?  My mother would still be paying me the same amount hoping that I wouldn't have to pay taxes on her payments because she is my mother.  I couldn't find anything about this in the IRS publication.  Does the IRS specify anywhere if there is such an exclusion related to family members?

3)  If 2) doesn't apply, could I consider my mother's rental payments as a gift, thus avoiding to be taxed on her payments to me?  I understand that I wouldn't be able to take a depreciation any longer, but I could still deduct mortgage interest and property taxes.

4)  The yearly "rental" amount I receive from my mother is about $30,000.  I understand that the annual exclusion of the gift tax is $18,000 (for 2024).  Could my mother pay $18,000 to me and another $12,000 to my wife and thus still be within the limits of the gift tax exclusion?

5)  Assuming that I could convert the property to a second home, would I have to recapture the depreciation from the past?  If yes, do I recapture the depreciation at the time of conversion or at the time of sale in the future?

Please provide exact reference to the corresponding IRS publication in your answer.  Thank you very much for all your help in advance.

[PatriciaV]

1) Yes, because your tenant pays fair market rent and uses the townhouse as her main home, this is considered a rental property. Otherwise, this would be considered personal use per the IRS (see What is a day of personal use? #2).

2) Yes, you can convert this to personal use. There is no exclusion for fair market rent paid by a related party who uses the property as their main home - the income must be reported as rental income. 

IRS Not Rented for Profit: 

1. "If you don’t rent your property to make a profit, you must still report your rental income, however, you can no longer deduct rental expenses."
2. "If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property for profit."

3) Reimbursement of expenses would not be considered rent as long as the activity was not an intent to make a profit. As a second home, you would be able to claim mortgage interest and property taxes, but no other expenses.

4) Per IRS Frequently Asked Questions on Gift Taxes, "The annual exclusion applies to gifts to each donee. In other words, if you give each of your children $18,000 in 2024, the annual exclusion applies to each gift." The included table shows the annual exclusion amount applicable in the year of the gift.

5) Accumulated depreciation would be recaptured when the property was sold. This article from The Tax Adviser (an authoritative source) discusses the tax consequences on the sale of a residence after converting a rental to personal use. These factors would also apply to the sale of a second home previously used as a rental.

[chag2020]

Thank you PatriciaV  very much for your thorough answer.

2) and 3):  how do I distinguish between my mother paying rent versus my mother reimbursing me for expenses.  Isn't that the same thing?  In other words, if she pays me for reimbursement, how can I argue my case to the IRS that she is not paying rent, which I would need to pay income tax on?  You are correct to say that my intention is not to make a profit, but simply to cover expenses.  It just happens to be the way that the reimbursement for expenses is the same amount as fair market rent.  I am assuming expenses would include mortgage interest, principal payment, insurance, property taxes and HOA.  But maybe my assumption is wrong with regards to what is included in the expenses.  Would you be able to guide me to a place on irs.gov or the IRS code that states my case of not receiving rent but simply getting my expenses reimbursed by my mother and thus me not being obligated to pay income tax on those reimbursements?  Would in that case, my property be considered a second home (personal use).  I do spend at least 14 days a year over there.

4) In case I don't have to pay taxes on my mother's reimbursement to me, I don't need to worry about the gift situation.  If not, I wonder if my mother's payments are still considered a gift if it is linked to her being able to stay at our property.  The IRS definition for a gift on your link states:  "Any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return."

5)  That's good news.  The link you provide is very helpful.  Do you have a reference to the IRS website or their code that describes this situation?

Thanks again for your help.  I really appreciate it.

[chag2020]

Could somebody please address my follow up questions?  Thanks a lot.

[chag2020]

From further research I learned that the reimbursement of expenses is in fact considered rent.  Also, my mother paying all the expenses directly is no different than her paying rent to me.  Lastly, her payments cannot be considered a gift as she is getting something in return for them.  Thus, I consider the first part of answer 3) of PatriciaV to be incorrect.

3) Reimbursement of expenses would not be considered rent as long as the activity was not an intent to make a profit. As a second home, you would be able to claim mortgage interest and property taxes, but no other expenses.

I am happy to be wrong.  Actually, I wish I'd be wrong, but unless somebody is able to proof it with a tax code reference, I will have to continue declaring my mom's payments as rental income.