Should you rent your investment property to a friend?

This article was originally published in the July edition of the Your Investment Property Magazine.

Renting a property to a family member or friend can be a win-win situation, but there needs to be some ground rules to ensure both parties understand how the arrangement will work. The key is to get a few things in place before anyone moves in so it's clear what the expectations will be.

First up, it's perfectly legal to rent an investment property to family or friends. It's also a landlord's right to set the rent as they see fit (as long as it's within the bounds of state rental laws). The Australian Taxation Office (ATO) has no problem with who you rent to or what you set the rent at. If you charge market-rate rent that's consistent with other rentals in the area, the ATO will treat you as any other property owner.

But if the property is rented out at mates' rates, that is, less than commercial rent, the ATO warns your claims for expenses on your investment property may only be allowed up to the amount of rent you receive. For example, if you'll be charging rent at $300 a week when market rent is $550 a week - around 55% of market value - you'll only be able to claim 55% of the deductions for the period. The rent you get will still be treated as assessable income but any losses and outgoings you make on the property may not be wholly deductible.

It's strongly advised you consult your accountant on what amount of rent would best meet your investment goals and allow for any altruistic discounts you might be thinking of applying. If you need to make the maximum deductions to keep your investment property financially viable, you'll need to explain this to your family or friends. They may have no issue with paying market rent and just be grateful to secure the property in a hot rental market.

If they were expecting significantly reduced rates, maybe it's best they keep looking around. You need to be sure that your prospective tenants understand that it's got to work for you as a business arrangement, no matter how well you know each other.

Don't skip the formalities

The next absolutely vital step is for both parties to sign a rental agreement, regardless of what your relationship is. You can find general tenancy agreement forms online. Just make sure you access the correct form for your state or territory. These agreements are a legally binding contract and set out how much the rent is and how and when it will be paid. They also provide standard terms of tenancy, outlining what the tenant and the owner can and cannot do. There's also a place for any special terms such as who'll pay for water charges or mow the lawn.

This may all sound very formal but it's important protection for everyone involved. Rental agreements need to be in place should you have to make any insurance claims covering accidents or damage to the property. For the tenant, a formal rental agreement can establish or maintain their rental history credentials and can also help their credit score. You can point out these mutual benefits should your prospective tenants baulk at formalising their tenancy.

Once you both sign a rental agreement, it needs to be lodged with your state or territory's relevant authority along with any bond payment you agree on. Generally, the maximum bond amount in Australia is around four weeks' rent but it's up to you and your prospective tenants to work this out between yourselves. Most jurisdictions don't require a bond to be lodged by law. You may choose to waive this if you feel you know your tenants well enough to trust them to do the right thing, but it can be a safeguard if something drastic happens.

Consider a property manager

If all this sounds just too daunting to be negotiating with your family or friends, your best bet is to appoint a property manager. You may just want them to set up the tenancy agreement and handle the paperwork or bond collection on your behalf. Having a third party looking after the business side of the arrangement can take the awkwardness out of the situation.

However, it is wise to keep them managing the property to allow yourself to stay at arm's length from day-to-day tenancy issues. The average property management fee for rental properties in Australia is typically around 6-8% of the monthly rent. But if you just want a manager do the groundwork for you, you may be able to negotiate a reduced fee for preparing the initial paperwork and collecting the rent each week while you take over the day-to-day management and maintenance issues.

Rental property owner Peter Cummins did just this when his daughter and two of her friends rented his investment property in inner-Brisbane.

"I explained the situation to the existing property manager and told them I would be putting a family member and two friends into the townhouse, but I would like them to prepare the usual documents and continue collecting the rent," Mr Cummins told Your Investment Property Magazine.

On advice from his accountant, he set the rent towards the lower end of comparable commercial rents in the area but not at a reduced rate. He then asked the property manager to prepare a rental agreement and continue collecting the rent on the property while he would take over maintenance matters, negotiating a reduced management fee.

His daughter and her friends contact him directly with any property issues which he handles himself or arranges tradespeople to attend to. They sign ongoing lease extensions and pay weekly rent through the property manager. In the two-and-a-half years they have been in the property, the rent has increased in line with prevailing rental market conditions although remains at the lower end of the range.

"I wanted it to be all above board for taxation purposes, so I have no issue paying an ongoing fee to a property manager to handle the legals and collect the rent," Mr Cummins said.

"That way, if the rent was going to be late, it's a property manager they'd have to answer to and negotiate with. It's good preparation for the real world.

"It has gone extremely well. There has never been a missed rent payment and I know the property is being well looked after. It's been a very good outcome for everyone."

"Tread carefully"

But not all friends and family rental stories are quite so rosy.

Over her years in the industry, principal of Sydney-based The Rental Specialists Jo Natoli has seen many friends and family rental arrangements turn sour and lead to irreparable relationship damage.

In fact, her best advice on renting to family and friends is quite simply "don't do it".

"I would highly discourage it," Ms Natoli told Your Investment Property Magazine.

"But if you're going to go down that path, you need to make sure you treat the tenants the same as any other tenants.

"There needs to be a proper lease in place, condition reports need to be done, and you've got to get an agent to manage the tenancy. The business side of the relationship needs to be as removed as possible from the relationship itself."

Ms Natoli, who's also a board member of the Real Estate Institute of New South Wales (REINSW), said on many occasions she's seen landlords come to a property manager for help after problems arose from putting family or friends into their property without an agent involved.

"By this stage, the personal relationship is usually gone and there is never a good outcome," Ms Natoli said.

"If you're thinking of handling it all yourself, the tricky part can come later - are you going to be telling the person they are living in squalor and degrading your property?

"What happens if someone loses their job and is unemployed and comes knocking at the door with their hand out? These things are best handled by an agent, and I wouldn't go half-measure either. Property management fees are tax deductible when you have a rental property so if you're going to put family or friends in your rental property, I would recommend an agent handle everything right from the start.

"Even then, you need to tread carefully. Anything that can go wrong is even more difficult when you're dealing with family or friends."

At the end of the day, you need to make your own decision as to whether it's a good idea to have your family or friends move into your rental property. It could be a brilliant solution all round or an unmitigated disaster. This will depend on your - and often their - personal circumstances and this is where it becomes difficult. It's never easy to mix a financial arrangement with the emotional stuff that can get in the way of a wise decision: a sense of duty, empathy, loyalty, wanting to do 'the right thing'.

That's why you should investigate the business side of the equation first up and if you decide to proceed, remove yourself from it as much as practical. As for the emotional side, only you can weigh that up. Safeguards can certainly help but even they are no guarantee that all will run smoothly. As Tolstoy said, happy families are all alike, but every unhappy family is unhappy in its own way.

Advice for renting to family and friends

1. Speak to your accountant: Below-market rent can reduce the tax deductions you can claim on your investment property. Understand the financial implications before you go ahead with any rental arrangement.
2. Be clear that it will need to be a satisfactory business arrangement for you: Let your family or friends know you have spoken with your accountant and set out what you expect to make it work for you. If there is pushback at this stage, it's probably best not to proceed.
3. Have a rental agreement: This will set the ground rules for the tenancy and provide a formal contract outlining standard terms for the landlord and tenants and provide an opportunity to make clear any special terms. It also sets out how much the rent is, how often it will be paid, and where it will be paid to.
4. Appoint a property manager: A property manager can be a valuable third party in handling day-to-day matters as well as any situations that may arise that could be awkward to deal with yourself, e.g. property damage or unpaid rent.
5. Direct any communications to the property manager: Stay out of any day-to-day issues or discussions about the property with your tenants/family/friends. Let it be clear from the start the property manager should be the point of contact for any property or tenancy matters.
6. Keep your landlord's insurance up to date: Landlord's insurance is vital no matter who is renting your property or how much you might trust them. Accidents and unfortunate events can still happen.

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