Why free rent has tax consequences

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Q. I have a relative who is a single, working mom. Her long-time childcare worker is having financial difficulties and needs a place to live. The mom has offered for the worker live in her home free in exchange for child care. No money would change hands. Are there tax liabilities? Should they have a lease agreement of some kind and would she be considered a tenant? Would homeowners insurance cover her?
— Trying to help

A. This is a very unique situation.

From a tax standpoint, what your relative — let’s call her Sue — would be doing is called “bartering.”

Bartering is the trading of one product or service for another, said Michael Green, a certified financial planner with Wechter Feldman Wealth Management in Parsippany.

“Normally we associate taxes with employment and income, but simply because no cash is changing hands does not mean there will be no tax consequences,” Green said.

Think of it this way: Although Sue’s nanny would be living in the house for free, the money the nanny saves on rent would actually be considered rental income to Sue at the fair market value, Green said.

And likewise, because Sue would receive free child care, the money she is saving by not paying her nanny actually counts as taxable income to her nanny, also at fair market value, Green said.

“The IRS pays close attention to bartering situations like these because they often result in taxes not being paid — which in this case is both employment and income taxes,” Green said. “Another concern is that this arrangement could possibly violate labor laws because Sue is avoiding the payment of all employment taxes — FICA and FUTA.”

Green said in this situation, Sue’s nanny would be considered a tenant and would need her own renter’s insurance to protect her personal property in the event of a loss.

“Homeowner’s insurance specifically excludes the personal property of a renter and only covers the contents in the home that belong to the homeowner,” Green said.

Plus, Sue would need to disclose to her homeowner’s insurance carrier that the nanny is residing in the home. This may increase the policy premium.

Green said the best scenario is to avoid entering into a bartering arrangement.

“Sue and her nanny should establish an official employment and lease agreement that clearly defines each person’s role, as well as compensation,” he said. “This way both parties are protected, and any negative tax consequences are prevented from the start.”

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