Say Your aging parents live in a home that has appreciated in value, but they’re no longer reaping any of the home ownership tax breaks during their retirement years. Sound familiar?
Good news: With one stroke of the pen, both you and your parents can win: They’d gain instant access to their home equity (without moving) and you’d pick up some generous new tax deductions.
How? Buy your parent’s house, and then rent it back to them – at the going rate.
Reasons for the sale/leaseback. Under the current home ownership set up, your combined family unit is overpaying the IRS.
Your parent’s mortgage is either paid off or the payments represent mostly principal at this point. Even if they still take interest deductions, your parent’s tax bracket might be low in retirement, so those deductions don’t provide much tax savings.
Here are two good reasons for your parents to opt into this plan:
- It puts cash in their pockets without them dipping into a home equity loan.
- It allows them to put their money into safer investments than the real estate market.
Transferring the house. To avoid gift-tax complications, pay a fair price for the home. Support the buying price for the home with a qualified and independent appraisal. Then, both sides should enter into a lease at a fair rental value.
One benefit: Courts have said that landlords can reduce their fair-market rent by 20% when renting to relatives. The lower rent reflects the savings in maintenance and management costs . (L.A. Bindseil, TC Memo 1983-411).
Don’t set the rent too low; the IRS might say the rental home is for your personal use. Therefore, your deductions might be limited to the mortgage interest and property tax, the same as if you owned a vacation home.
Taking deductions. Once you own your parent’s house, you’re entitled to reap the tax benefits of owning rental property.
That includes taking write-offs for operating expenses, such as utilities, maintenance, insurance, repairs and supplies.
You also can claim depreciation deductions for the home, but you can’t depreciate the cost of the property apportioned to land.
So obtain an appraisal allocating the price paid between the depreciable structure and the nondepreciating land. You can use these deductions to offset the rental income received from your parents. You can take any suspended losses when you sell the house.
Bonus benefit: Once you own the house, you may be able to write off occasional travel expenses you incur when visiting the house (your rental investment).
Endgame: Eventually, your parents won’t be able to live in the house. Then , you can sell it, rent it to another tenant or move in. If you move in and make it your principal residence for at least two years, you can sell it and shelter another $250,000 or $500,000 worth of capital gains: a true bonanza!