Because the IRS is staffed mostly by idiots just like any other government agency.
About 20 years ago I had some confusing tax issues due to a family trust. The instructions were ambiguous so I called the IRS help line. The first person I talked to had an answer that did not make any sense if I was reading the instructions logically. The second person at the IRS had a completely different answer, that also was different that the conclusion I had come to on my own. I called a third time and after getting a third completely different answer I went with what I had determined on my own before calling. Considering I never got anything in the mail from the IRS stating I had done my taxes incorrectly I have to assume I was right or right enough.
You could always ask for an official advisory opinion.
Wow. I googled my scenario, and half the people say no I do not have to pay taxes because a rental property is considered a business, and if the rent paid = mortgage costs, then it's a wash and neither a profit or loss, and therefore, doesn't have to be reported as income.
Others say yes, you have to pay taxes.
Others say no if its a family member since it can be considered a tax free gift (up to $12,000 or so). In my case it is a family member renting, so now I'm really confused. And the rent is exactly $12,000 a year.
I will just go to an income tax guy this year and let them figure out the mess, and I'll go by their recommendations.
Wow, your attorney has no clue.
I assume you do not make a living owning rental property, since this is rented to a family member for the cost of the mortgage. Reporting the property would be done on Schedule E.
Publication 527 defines rental income as "any payment you receive for the use or occupation of property." Since the loan is in your name the IRS considers the payment of the loan on your behalf to be constructive receipt of the income, regardless of whether you actually receive it or not.
Schedule E allows you to deduct the mortgage interest on the loan as well as the depreciation of the property.
You are not allowed to deduct the principal and interest payment on the loan. Your attorney is backwards on what you can do.
If you do not rent properties for a living to qualify as a real estate dealer you cannot file on Schedule C so there is no way you could try to claim the P&I payment on the loan as a "business expense".
Gift tax liability lies with the giver, not the recipient. In general any one person can receive up to $13,000 (for 2011) in gifts from any other person before the giver begins to incur gift tax liability. Gift tax is due not only on cash gifts but also on property and potentially services valued at fair market value. Giving a non-immediate family member a place to live outside of your primary residence could be considered income in the FMV of the rent.
In your case you could say that the $1,000/mo value of the house is a gift and the $1,000/mo cash received is a separate gift. Since both values are under the annual threshold no gift tax would be owed. The problem is that in order for the IRS to consider it a gift the recipient must not reciprocate with something of equal value. In other words, since you provide housing worth $1,000 and the family member provides $1,000 cash neither is considered a gift.
You might be able to continue on not claiming it as proper income on the Schedule E, and you might never get caught, but if you get audited your nuts will be in a vise.