Renting to Parents

My parents recently decided to transfer their primary home to my two siblings and me. They wanted to do it while still living, and we wanted to get the house at a stepped-up basis, so they simply gifted the purchase money to us ($250,000) rather than gifting the house. We purchased the house at appraised value and my parents filed a gift tax return. My parents continue to live in the house, so they are renting it from us at market rates. We show the rental income on our tax returns. We have been gifting the rent back to them, so there is no net money transfer. To document the rent payments and return gifts, I have simply been recording the "transactions" in a memo to our tax file; we don't actually send checks back and forth each month.

My question - Is the memo enough to demonstrate to the IRS that my parents are renting and we are gifting, or do we need to actually send the checks back and forth?

You could just keep the rent for the whole year and write one check back to them at the end of the year. As long as the rent is under $11k, you wont have to file a gift tax return.

Ccbrown,

I trust you are taking depreciation on your rental.
You should be taking that now, and filing a Schedule E for the rent you received.
Of course you can deduct other expenses from your income, like repairs, insurance, legal fees, mortgage intrest.

The depreciation will need to be taxed as income when you sell the property, at the lower of your nominal rate or 25%. This is necessary even if you do not take the depreciation now, the IRS assumes you did take the depreciation.

How you receive the rent, and what you do with this income is up to you.

You should read IRS Pub 527, Residential Rental Property.