In principle there is no legal reason why you cannot rent property to a relative. However, doing so -- particularly at below a fair market rent -- can limit the tax benefits you get. It will also restrict any housing benefit your relative may receive.
General renting tax rules
As a general rule, any income you receive from renting out a property you don't live in is classed as taxable income. You can deduct any expenses related to the property such as maintenance. A special "Rent a Room" scheme means that you can receive a certain amount of rent tax-free if the room is in the property where you live. As of April 2013, this amount was £4,250 a year. If you take advantage of the "Rent a Room" scheme, you cannot claim deductions for the relevant expenses.
Most relatives are classed as a connected person. This covers your siblings, parents and grandparents, along with your children and grandchildren. It also covers your spouse or civil partner, along with his or her siblings, parents, grandparents, children and grandchildren. The spouse or civil partner of anyone mentioned on this list also counts as a connected person for your tax purposes. This means, for example, that your wife's granddaughter's husband is connected to you.
Renting to a connected person becomes significant if you are charging below the market rent. If challenged, it is up to you to prove what a fair market rent is by providing a written quotation from a letting agency. If you charge below market rent, then any deductions you claim relating to the property cannot exceed that actual rent you are charging. This means you can't, for example, charge a relative £5,000 a year rent and then claim a £6,000 deduction for maintaining and fixing the property.
If you rent a property to a relative but don't charge any rent, you cannot claim any deductions relating to that property. This is because the relevant expenses are not classed as purely for business. Only expenses that are entirely related to a business (such as letting a property for commercial gain) are tax deductible.
As well as the tax implications you face, renting a property to a relative can affect his or her benefit rights. If you rent a room in your own home to a relative, he or she cannot claim housing benefit. If you rent a room to a relative in a property that you own but don't live in, your local council will check the circumstances. It will not pay housing benefit if your rent is below fair market value, or if you are not paying the same amount consistently.