Your parents have helped you through the years, now is your chance to do something to help them. Do they have a house (their primary residence) that they want to continue to live in, but can’t afford or are not getting all they can out of it anymore? Maybe they can’t itemize deductions on their tax return anymore or itemized deductions allowed don’t provide much tax savings.
How can you help them?
Buy the house, and then rent it back to them. Make sure you do everything at “arms length” so there won’t be any potential problems with the IRS.
What does that mean?
The house should be sold at fair market value and leases should reflect fair rental value. The fair market value of a home can be supported by analyzing prices of recent comparable home sales in the neighborhood or by obtaining a professional quote. Proper valuation will help avoid potential gift tax issues. You and your parents can enter into a lease for any term you both agree to, but a long term lease may make your parents feel the most comfortable. Again, checking local comparable rental listings is a good way to support a fair rental value.
What are some of the benefits to your parents? To you?
Your parents will now have available cash, equal to the value of the house and will still be able to live there. They can invest the cash in safer and more liquid type investments that will generate a cash flow for them. When they sell the house to you they may have a gain, but if the total gain doesn’t exceed $500,000, it won’t be taxable. Only the portion of the gain in excess of $500,000 will be taxable. The gain will also likely be subject to long term capital gain treatment for federal tax purposes, which maxes at 15%.
What are the benefits to the children?
You now own rental property, and will have to include the rental income on your tax return. However, you also will be eligible to deduct a variety of rental expenses, including property taxes, mortgage interest, utilities, maintenance, insurance, repairs and supplies, along with depreciating the cost of the house. Note that depreciation is only allowed on the cost allocated to the house, not to the land. If you have a rental loss in any given year, it may be limited, or fully disallowed in that year. However, such disallowed losses aren’t lost forever. Any suspended losses not taken during the rental period will be allowed upon sale of the house. Also, since it is investment property, any gain on the sale of the house will be taxed at long term capital gains tax rate, which is currently 15%.
At some point your parents won’t be able to or won’t want to continue living in the house. Depending on the real estate market and your personal situation at the time you would have several options.
- Find another tenant,
- Sell it,
- or move into the house.
Depending on this decision, gain on the disposition would be taxed differently on each scenario. If you decided to move in, and make the home your principal residence, up to $500,000 of gain can be excluded upon the sale. Alternatively, if the home is sold while it was still deemed a rental property, the full amount of the gain would be taxed at the long term capital gains tax rate, which is currently 15%.
As you can see, there could be benefits to both you and your parents related to purchasing your parent’s house. Such a decision should involve family members in agreement.
Should you have any questions related to this planning idea, contact your Marcum Tax Professional.