Navigating Lease Agreements with Family: Why Formalization is Crucial

What Exactly is a Family Member Lease Agreement?

A family member lease agreement is an arrangement entered into between a landlord and tenant whereby the tenant agrees to lease the property from a family member for a discounted price. This type of lease may be entered into for a number of reasons, including financial considerations, assisting an aging family member, or simply for the convenience of one or both family members.
Family member leases may be particularly attractive to individuals who are elderly or disabled as they may help these individuals save funds that would otherwise be spent to pay for rent so that they can devote more funds to their medical needs. In addition, family member leases may be useful as a way for an individual who has moved in to care for a family member to provide them some assistance with their expenses. The lower rent and possible inclusion of utilities may result in substantially reduced living costs for the individual being cared for.
Family member leases do have some potential disadvantages , however. While the rental payments are likely to be lower than market rate, if the landlord does not own the property free and clear any rental payments would generally be required to be paid to the mortgage lender and this requirement may complicate or interfere with the person who is leasing the property use of the property, such as by limiting their ability to make alterations to the property. In addition, family member leases may cause disputes between family members if the relationship between the owner of the property and the person leasing the property deteriorates, or if other family members feel that the person leasing the property is being unfairly compensated or not paying their fair share of rent compared to others. Finally, as with all leases, a divorce or death of the owner of the property could cause problems for the individual leasing the property as the family member who was the landlord could terminate the lease.

Legal Necessity of Written Lease Agreements between Family Members

Understanding Family Member Lease Agreements: Key Tips and Considerations
We found that far too many people thought it was acceptable to have no formal lease agreement between family members and set arrangement to have a landlord-tenant relationship between relatives, based merely on nothing more than trust. Yet, relationships between family members are not infallible, and, unfortunately, these informal arrangements may not be worth the paper they are not written on. In fact, if a lease is between family members, you may not be able to enforce it in court based on our unique landlord-tenant statutes. This section clarifies that to enforce a lease with a family member, you should have a lease between family members in writing. A poorly written rental agreement between anyone can cause problems—but a deal among family members, business partners, and friends could have even larger implications. The failure to properly document your agreement could cause disputes over eviction and other issues, or result in taxation and liability that a written lease could have helped you avoid altogether.

Key Clauses in a Family Member Lease Agreement

There are several essential components and clauses that must be included in any family member lease:
Duration of the lease: As you might expect, there are numerous possible options for the length of the lease. In fact, even though it may seem appropriate to have a "life-long" lease between family members, you really should fix a specific term and have a lease for a period of time. That term can be one year (as it typically is in most commercial leases), or it could be some other period of time of your own choosing. The term will also determine how often the rent is paid, either weekly, monthly or annually. For tax purposes, specify whether the rent is due at the beginning of the month, the middle of the month, or the end.
Rent: You and the family member will have to agree on the amount of any rent to be paid, as well as how often the rent is payable. In most cases, the rent should not be nominal, but in any case, it should be an amount that would be paid by a third party in an arms-length transaction. If the rent is nominal, the IRS may consider it a gift, which would result in a taxable gift situation and perhaps even a gift tax liability. The term "arms-length" means that the parties to the transaction are unrelated and not otherwise associated with each other. Since this lease is between relatives, the requirement for an "arms-length" transaction will probably be met if the rent is paid and is not nominal.
Maintenance obligations: This is where disputes will occur if it is not specifically delineated in the Family Member Lease. You will need to decide if the family member occupies the property and is responsible for all costs of maintenance, or if the lease will designate the landlord as responsible for all costs of maintenance. (A husband and wife can decide between themselves as to how to pay for maintenance if the lease is between them.) Some of these decisions may have an impact on whether the family member residing in the property is considered a tenant or a licensee. See a discussion on the difference between a tenant and a licensee. This issue will really only be important if the family member occupant defaults on his or her lease payments and the property has to be evicted from.
Taxes – real estate and otherwise: These obligations will fall into the same categories as the maintenance obligations.
Utilities: Same issues as above with maintenance obligations.
Alterations and repairs: Typically, landlords require the tenant to obtain advance approval before making any alterations or repairs to the property. You will need to decide if this will apply when the lease is between relatives.
Renewals: Be sure to specify in advance if the lease should be renewable once it expires, and whether it can be renewed indefinitely.
Termination: Specify here if there are any special notice requirements for termination of the lease. If both the landlord and tenant have the ability to terminate the lease, decisions will have to be made about notice periods for the lease termination.
Default: Include a provision on what happens if a party to the lease is in default. What steps should be taken to be considered out of default, and what remedies would be available? What happens if the family member tenant fails to pay the rent? Do you have the right to non-judicially evict the family member tenant?

Common Mistakes in Family Member Leases

Family member leases often come saddled with problems that, if not addressed, can lead to a breakdown of the relationship. And when family is involved, the lease is often informal and undocumented. If there is a formal written agreement in place, it is not likely to be clear, detailed, comprehensive, or enforceable in a court of law. Because of these shortcomings, family member leases are particularly prone to misunderstandings and disputes. Unstated or forgotten terms may prove to be the source of an unpleasant surprise. And the warping effects of emotion and relationships makes it difficult for family members to get past the issue and see the deal for what it actually is.
The failure to understand and set out some of the standard lease terms is one major pitfall that can arise in family member leases. Common issues that should be addressed in the lease include:
Another common oversight that occurs when drafting a lease is the failure of the landlord to actually put the lease in place. It is tempting, of course, for family members to waive formalities and start the family member lease on a more casual basis. This practice involves risks, however. A cordial relationship can sour. Circumstances may change, particularly in the case of leases that are to run for a long period of time.
When the relationship does erode, the landlord is well advised to move quickly to complete the lease and make it formal in order to create a legally protected relationship. The failure to take this step can have significant consequences. The landlord may need to evict a particular tenant, as opposed to finding another home for her. The landlord may need to sell the property. The landlord may want to make improvements to the property that require access by the landlord. Even the best of families will not react favorably to attempts to enforce rules which have not been clearly established in the lease. To be effective, the terms of the lease must come to mind whenever a situation arises.
The better course in these situations is to treat the family member lease as you would any other. A written lease protects all parties. It lays out the expectations clearly. It can be enforced against the tenant if the tenant fails to comply with its terms. It can be enforced against the landlord if the landlord fails to comply with its terms. It sets up the ground rules before a problem arises. Whether or not the lease is formal, the document should be detailed enough to address the issues that most commonly arise. When it comes to a family member lease, there is no such thing as overkill.
Finally, cover the issue of termination in the lease. What notice must be provided before the lease terminates? Can the lease be renewed? What happens at the end of the lease term? Many unresolved issues play out in family member leases where the parties did not spell out the agreement. In some cases, one party is surprised to find himself in a position from which he cannot exit. The failure to address these issues can ruin a good agreement.

Tax and Financial Implications

As with any lease payments, the landlord is most concerned about the tax treatment of payments. If the landlord is not otherwise reporting income from a passive activity, and has not elected to receive all or part of the rent in front-loading lease payments ("advance rent"), rent payments will constitute taxable income for the landlord as follows for a family member: Now the landlord who is fabricating these lease payments may think he is being smart by not declaring the income on his tax return. Unfortunately, the IRS has a knack for sniffing out that which is not reported by the respective party. The IRS audits thousands of tax returns every year, and its interest is always piqued by anything that seems out of the ordinary. In particular, the IRS will audit family members who appear to rent out investment property (based on depreciation deduction taken and/or rental income reported on Schedule E) to a member of their family. As explained below, the IRS is unlikely to ever see the purported "tenant’s" rental expenses; the claim of no rental income by the tenant is a "red flag" that will likely trigger an audit. As recently as October 2016 , the IRS issued a ruling on this very topic recognizing that money refunded from the tenant to the landlord is an indicium of a lease for less than fair market price. The IRS concluded that the tenant must include a portion of the advance rent funds returned to him by the landlord as income under the lease. This fact of life is particularly painful for the "tenant" because he must defend himself by proving that he paid rent to the landlord; and good luck to him because the landlord does not have to report the purported "rent." (If you are married to your tenant, your joint return will inevitably be audited, or even worse, the IRS may audit your spouse once he files a separate return in subsequent years). Assuming the tenant survives the audit, there are additional tax implications to consider. Also from the tenant’s standpoint, a sale of the home by the landlord could be an unmitigated disaster. Since the tenant has never paid fair market value for the property, he will be forced to pay capital gains on the entire appreciation of the land. All costs of acquisition and improvements to the property will be disregarded by the IRS since they were never made to the property but rather were considered expenditures by the landlord. Compare this with a conventional homeowner who would depreciate the cost of improvements over several years, receive a larger "basis" for capital gain purposes and thus pay less tax when the property is sold or transferred. Despite all of the red tape involved with formalizing the relationship between a tenant and landlord, it is worthwhile to remember that useful and important tax strategies are lost without them.

How to Draft an Enforceable Lease Agreement

The process of creating a legally binding lease agreement should incorporate all the essential elements of a legally binding contract, otherwise the court might not uphold the agreement if it is challenged down the road. A binding contract requires three elements: an offer, an acceptance, and consideration (i.e., the exchange of something of value).
Take these steps to create a family member lease agreement:
Put everything in writing. It’s best to have a written lease agreement, even if it’s between family members. A written agreement reduces the possibility of arguments later about what was promised or the specifics of the terms.
Draft the agreement or lease. You should draft the agreement to be as precise as possible. For example, specify the amount of rent, security deposits, utilities, the number of persons who will occupy the property, and many other details. You can always do a very basic rental agreement or find one online that covers the basics.
Preparation should take into account the state, county, and city where the property is located, since laws and ordinances regarding renting out property can be different.
Other items that must be addressed are taxes, repairs and maintenance, insurance, pets, and whether smoking is allowed.
Document the agreement signing.
The parties involved with the lease or rental agreement should sign it and keep a signed copy. You might also want to have it witnessed or notarized to further validate it. Be sure to take photographs of the property and include those with the lease.
Also, you might want to record the lease with your local tax assessor’s office. Generally, there is no cost to record a lease. Recording might assist them in determining whether the property can be rented or not.
When is it in your best interest to seek legal advice?
You should seek legal advice if you are not confident that you have covered all your bases, or if you wish to avoid the stress of sorting out issues between family members. A lawyer can assist you with drafting an effective document that protects your interests on many issues.
A lawyer also can help you set the amount for rent and determine what options are available for financing or getting a loan to purchase property. That also includes determining whether you might qualify for a business loan, or if there are any special programs for those trying to get a loan to become a first-time landlord.

Resolving Controversies and Issues with Family Member Leases

Disputes and conflicts between landlords and tenants are commonplace, but when the landlord is a family member and the tenant is a spouse, child or other relative of the landlord, the disputes can be even more contentious and costly. This can be problematic from a legal perspective, especially where family members are renting from one another without a written lease agreement.
Family member lease agreements that are in writing can work to mitigate disputes and misunderstanding, but even where they are not, conflicts can be avoided or resolved without damaging relationships and adding to financial and emotional costs.
The first thing you want to do is to consider potential sources of conflict and draft accordingly – allocating responsibilities and defining expectations for what happens when things don’t go as planned. Anticipating the most common areas of conflict not only creates a framework for management but also serves to diffuse existing tension between the parties.
Sometimes, however, there is no history on which to draw, and the source of conflict may be entirely unforeseen. This is where frank and open discussion is key. Each party should be prepared to listen and discuss the issues at hand, from perspective to perspective. If neither side is communicating openly about their needs and expectations, a frank discussion is in order. If necessary and if you live in Ontario, you may be able to obtain assistance through the Residential Tenancies Information Centre (RTIC), the Landlord Tenant Board (LTB) or Mediation and Adjudication Service Ontario (MASO).
On the other hand, sometimes a mature and frank discussion about the sources of conflict just doesn’t work. In this case, it can help to bring in an impartial third party to act as a liaison and to keep things reasonable and calm. Third-party interference can be helpful in keeping the peace by providing guidance and intervention where necessary, but you and your family member may be more prepared to go down this road if you have already put solid contract terms in place.
It is important to be respectful of your family member’s reputation and to recognize that he or she may be uncomfortable with the public nature of a proceedings before the Landlord-Tenant Tribunal. You may still want to consider contacting an outside professional, such as an attorney or family counselor.
You also don’t want to overlook the fact that some conflicts do demand outside legal intervention. Although most disputes are manageable with the right amount of open-mindedness, courtesy and patience, some situations become more serious and can involve allegations of theft, vandalism, assault, domestic violence and other illegal acts. When this is the case, calling in the police or other authorities may not be a matter of choice.
A good lease agreement is actually your best gun for dispute resolution in the long-term. A clear, well-thought-out lease will:
All of these factors together create a legal contract that should help to minimize the occurrence and escalation of disputes. You will still need to communicate openly, but you will have an agreement in place that allows each party to hold the other accountable.
Whenever possible, be proactive in defending your family relationships by putting together a family member lease agreement that will protect both you and your housemate.

Why You Should Consult a Lawyer

An experienced attorney can provide clarity on many of the issues associated with drafting and modifying an agreement. Several provisions that seem straight-forward may have a host of implications that only an attorney will be able to identify. An experienced attorney can also customize a lease agreement based on the particular needs of the landlord and tenant and structure the property management duties and obligations in a way that best suits your situation . Further, attorneys at Withers will be happy to address any specific issues you may have with respect to your family member or private lease agreement before you enter into a lease and discuss any additional provisions that may assist you in avoiding misunderstandings with your family member or private tenant.