Be Careful When Leasing A Home To Relatives

By: Tamara Pow

Many people are very fortunate here in the San Francisco Bay Area to have acquired so much wealth in their real estate, both their homes and their vacation homes, as well as homes held for investment. As a result, I am often asked to assist my business and real estate clients with a personal matter – leasing a home to a family member.

Leasing a residence to a family member can be hazardous in many ways.

Before you do so, you should think carefully about whether you would be willing to enforce the lease or sue your relative if they do not perform under the lease. Think about evicting your family member… then think about what Thanksgiving will be like next year. However, there is also a tax issue to think about – renting to a family member may mean that you cannot take any tax deductions for losses on the property.

The general rule is that if you receive rental income for the use of a dwelling unit, such as a house or an apartment, you may deduct certain expenses such as mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation. These expenses will reduce the amount of rental income that is subject to tax, usually providing tax losses for you as well (subject to certain limitations). However, this is only available if you are renting to make a profit and not if you are using the house as a personal residence.

The IRS says you are using a house as a personal residence if you use it for personal purposes during the tax year for more than the greater of 14 days or 10% of the total days you rent it to others at a fair market rent. You are considered to be using a house if a member of your family is using it, unless they pay fair market rent. A recent tax memo confirms the IRS is enforcing this rule. In Okonkwo (TC Memo, 2015-181), the parents rented out a house to their daughter for $2,000 per month, much lower than the $6,000 fair market rent they had received previously. They deducted the mortgage interest and depreciation. The Tax Court held that the losses are not deductible because the tenant is a family member paying below market rent, so her use is treated as use by the owners, her parents. Because her parents are considered to use the property for more than 14 days or 10% of the total days rented to others, they get no rental loss deductions.

Here are some other special rules you should be aware of:

If you use a house for both rental and personal purposes, you have to divide your expenses based on the amount of rental use and the amount of personal use. Your loss deductions will be limited to the rental income, but you may be able to carry forward some losses to the next year. You may still be able to deduct the personal use portion of expenses such as mortgage interest, and property taxes.

If you rent your personal residence for fewer than 15 days, you do not have to report any of the rental income (and you do not get to deduct any expenses as rental expenses).

Sources:

IRS Topic 415, Renting Residential and Vacation Property, Page Last Reviewed or Updated: August 31, 2015

The Kiplinger Tax Letter, Vol. 90, No. 20, September 25, 2015.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Capital Structure For Start-Ups: Part I

By: Robert V. Hawn

As a corporate attorney in San Jose, California, I help a lot of high tech start-up companies get up and running. One of the major decisions that requires a lot of time and discussion is how the new corporation should set up its capital structure. In this series of blogs, I hope to explain some of the basic issues and concepts to help founders understand how to approach building this important aspect of their new business.

Closely Held Corporations

Corporations are formed to enable founders to accept outside capital by selling ownership interests, or shares, in the corporation. Remember, stock is merely a share of ownership in a corporation. Shares that aren’t sold or otherwise provided to employees, investors, or others are held by the founders. So, one of the basic issues that a founder will want to know and keep track of is how much of their corporation they own. If you own all of the stock of a corporation, you own the entire corporation. If you just own a third of the stock, then you just own a third of the corporation. Simple, right?

The example above is typical of a corporation that is held by very few people. It is what lawyers refer to as a “closely held” corporation. A closely held corporation is typical where the stockholders are actively involved in the business. Stock rarely changes hands, and it is unusual for new stock to be issued. In that situation, it is easy to determine how much of a corporation each person owns.

Outside Investor

Now, let’s make things a bit more complex. Let’s say that our corporation has three equal shareholders, who bought their shares for $1 each, and an investor has agreed to put some money in the company. After discussion, which, of course should include advice from your corporate lawyer , you decide that the corporation is worth $300, and that the investor can hold ¼ of the corporation, or 100 shares, for $100. Before the deal is done, each shareholder owns 1/3 of the corporation or 100 shares each. There are 300 shares outstanding . After the deal is done, there are now 400 shares outstanding and each shareholder now only holds only ¼ of the corporation, although they still each own 100 shares. This reduction in percentage interest is called “dilution”. If it is a very important concept to remember. It is common to say that your interest in the corporation has been diluted from 33% to 25%, even though you hold the same number of shares. Make sure you understand it before you go on.

What is interesting about the dilution example is that the percentage of the old stockholder’s ownership has gone down, but the value of their ownership has remained the same. This is because the addition of the $100 in investment capital has increased the value of the corporation from $300 to $400. The old stockholder now owns ¼ of a corporation worth $400, and the value of the ¼ ownership remains at $100. (despite the “dilution”).

Stock Options to Key People

In a start-up corporation , the structure becomes a bit more complicated because certain types of interests are issued which can convert into stock of the corporation. Let’s see how that impacts the percentage ownership of each stockholder.

In our example, let’s say we want to provide an incentive to a key employee. One common approach is to provide an option. The cool thing about the option is that the employee doesn’t have to buy their stock until they can get some money for it. So, often, employees just hold onto the option and don’t turn it into stock (a process called an “exercise”) until they need to. By then, they hope the value of the stock has increased and they can make some money. One key concept is that if the option is never exercised, you never get stock, and there is no ownership interest in the corporation. In other words, an option does not represent ownership; only stock represents ownership.

You may want to determine ownership, however, if you are selling your corporation and you know the option will be exercised. So, how do you determine ownership where someone holds an option, but not the stock? Very simply, you assume that the person exercises their option and turns it into stock. Once you do that it’s easy to determine the percentages.

In the example above, let’s say our employee is provided an option for 20% of the corporation, or 100 shares. If you look at just the percentage of the ownership before the option is exercised, then each person holds ¼ of the corporation or 100 shares out of 400 shares. When the option is exercised, however, there are now 500 shares outstanding. Each stockholder holds 100 shares, or 20% of the outstanding stock.

The number of shares of stock determined assuming options have been exercised (among other things), is called the fully diluted number of shares. The fully diluted number of shares is an important concept because it is often used to set the value of a single share of stock in an investment deal. In the next blog on capital structure for start-ups, I will discuss how investor stock affects the number of fully diluted shares, and your percentage ownership.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Bob Hawn Presented at the Annual Meeting of the State Bar of California

October 8, 2015 – Robert Hawn presented at the “Basic Legal Skills for Advising Clients Doing Business Online” seminar at the Annual Meeting of the State Bar of California on October 8, 2015.