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December, 2005 Tax Tip

Maximize the Benefits of a Family Residence

If you have retired parents that own a home with little or no mortgage, there is a tax strategy that would allow them to receive extra cash while allowing you to take the valuable tax benefits.

You can buy your parents’ residence in an installment sale and then lease it back to them at a fair rental value.  If your installment payments to them are greater than their rental payments, they would have extra cash income each month.  The cash outflow to you is made affordable because of the tax deductions you get as the owner of the property, including interest, real estate tax, and other rental operating expenses.  You would also be entitled to depreciation deductions.  These deductions would, in all likelihood be of much greater tax benefit to you than they would to your parents. 

Your parents would be removing the value of the property from their estate while perhaps paying little or no capital gain tax due to the $500,000 home sale exclusion.

Will this strategy work?  Yes, if done properly.  The sales price must be at arms length, meaning it is the price that would be paid by an unrelated third party.  The interest rate should also be the going rate at the time of the sale.  While the rental your parents pay should similarly be at arms length, court cases have held that “arms length” can be lower than normal if renting to relatives.  The lower rate is justified by the reduced repair, maintenance and management costs.

What happens when your parents no longer live in the home?  You can then sell it, re-rent it, or move into it yourself.  If you move in and live there for at least two years, you can then sell it and get a $500,000 ($250,000, if unmarried) capital gain exclusion.  However the gain, to the extent of depreciation taken after May 6, 1997, would be included in income.

 

 



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