Giving Friends, Family a Break on Rent Can Cause Problems When Claiming Tax Loss

Q My son lives in a rental home that I own. He is behind on his rent. Must I report the money he owes me as income because he ismy son?

--J.F.

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A If you do not intend to report a tax-deductible loss on your rental home, your question is moot. The Internal Revenue Service insists that fair market rents be charged to family members and friends to protect itself against “inside” lease agreements that essentially are subsidized by taxpayers at large.

Here are the general rules: If you rent to a family member or friend for less than fair market value, your property loses its rental status in the eyes of the IRS and becomes, instead, a second home. Then it is subject to the tax rules governing vacation homes, which limit deductible expenses to the amount of your income.

The bottom line is that you can’t report a loss on the home’s rental. So, if the fact that your son hasn’t paid rent for several months puts your rental operation in the red, you can’t claim the loss on your taxes. However, if you don’t have a loss regardless of the rent you’re still owed, then you only have to worry about the amount of the debt you are forgiving.

You may give any individual family member $10,000 per year without gift-tax consequences. If the amount of forgiven rent is less than $10,000, you can consider it a gift. If it’s more, then you must report the excess to the IRS as a taxable gift. Although you may owe no tax on it, the excess will be deducted from your $600,000 lifetime, tax-free limit.

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Q My husband, who has been retired for years, recently suffered a stroke and is not recovering. How can I find out whether his pension ends with his death? I had a friend who lost her husband’s entire pension when he died, and I am fearful this could happen to me.

--D.S.

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A First, there is a law that provides for just the sort of spousal protection that you are talking about.

Under the Retirement Equity Act, which became effective in 1985, a spouse must consent to the type and terms of the pension plan a worker elects to receive at retirement. The law was designed to prevent just the type of horror your friend undoubtedly experienced when she learned that her husband’s pension did not continue, even at a reduced rate, after his death.

It is possible that this law became effective after your husband elected the terms of his pension, but you can still find out what those terms are. Simply contact the pension plan administrator at his former company.

In addition, our experts advise that it may be possible for your husband--if he is not incompetent or completely incapacitated--to change the terms of his pension payment. Again, you can check this through the company.

Our advisors say your best bet is to check the terms of the pension with the company and, if necessary, attempt to change them to suit your needs.

Readers, even if you’re not at or near retirement, now is probably a good time to check to see how your pension plan is structured. Do payments continue when you die? If so, at what level? Are you satisfied with the choices you made years ago, when retirement seemed remote? If not, can you change them? Should you?

This is not an issue just for older folks. Make sure you and your family are adequately protected.

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Q Last year, I left my job to start my own business. At the time I left, I was fully vested in a defined benefit pension plan. What will my tax obligations and penalty charges be if I want to take my accumulated pension as a lump-sum disbursement?

--P.T.

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A If you are under age 59 1/2, your distribution would be fully taxable under most circumstances. Furthermore, you will be hit with a 10% penalty charge for early withdrawal of your retirement funds. There can also be a 15% penalty on amounts distributed in one calendar year in excess of $150,000, regardless of the recipient’s age.

If you are over age 59 1/2, you will avoid the 10% penalty. Furthermore, if you turned 50 by Jan. 1, 1986, your tax obligation on the disbursement can be calculated either at your highest applicable tax rate or based on a special five- or 10-year income averaging, which usually permits a lower tax rate to be used. Internal Revenue Service Form 4972 has a work sheet for calculating the special income averaging.

You should also note that you can avoid taxation on the disbursement entirely if you roll over the funds into a qualified individual retirement account within 60 days of cashing out of the plan.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com