Bargain rental to son will create tax issues
Q: My son is married with two children and both he and his wife are elementary school teachers. They are unable to afford the purchase of a home. My wife and I have offered to buy a home for $320,000. We would make an $80,000 down payment with a $240,000 mortgage. We would then rent the home to them. But they eventually would want to own the house. My thought is that I would sell them the home piecemeal. For example, I could sell them 15% of the home for $12,000, which is 15% of the equity. They would then pay 15% of the mortgage, taxes and insurance. I could charge rent for 85% of the home. This plan allows them to slowly increase their ownership as they can. My son likes this idea and thinks it can work. But he asked me how we would report this for taxes and I have no idea.
A: Your proposal seems to make you and your son partners in this house. Partnership tax law is fairly clear. What is less clear is, what is a partnership for tax reporting? I do not think you have a partnership.
A partnership for tax reporting involves operating a business together with the intent of sharing costs and revenues. Your plan does not involve operating a business nor does it involve sharing revenues.
The tax law does have something to say about co-ownership arrangements involving personal use by an owner. In general if property is rented to a family member the property is treated as personal use property unless the family member pays fair rental value.
This means that if you own 100% of the property and rent to your son, you can treat the arrangement as a rental only if fair rent is charged. This would allow you to deduct all expenses, including carrying charges and depreciation.
If fair rent is not charged, even if it is 95% of fair rent, then your son’s use is treated as personal use by you. You can deduct mortgage interest and property taxes (limited to $10,000 total for the sum of all property and income taxes you pay), but not operating expenses or depreciation.
If a co-ownership structure, the law says that you can treat your ownership share as a rental investment provided your son pays fair rent for the percentage of the property that you own. But this is so only if the ownership is what the law calls a “shared equity financing arrangement.”
You probably will want to report your ownership share as a rental investment. This requires two things. First, a shared equity financing structure. Second, a fair rent charged for your ownership share.
I can’t tell you what fair rent is so I will focus on the first part. A shared equity financing arrangement requires that both you and your son have a “qualified” ownership interest, that one of you use the property as a principal residence, and that the party who uses the property pays rent for the share they do not own.
If done properly, you can report a rental property for your percentage share, claiming all operating expenses and depreciation deductions in addition to interest and taxes (not limited to $10,000 because they relate to an investment).
Your son will be able to exclude any gain realized from his share if he owns and uses the property as his principal residence for at least 2 of the 5 years before sale.
To do this “properly” both you and your son have to have an undivided ownership interest. The best way to do this is to have separate deeds for fractional shares of the property. Your plan will make this cumbersome if you plan to allow your son to periodically grow his interest.
The tax law does recognize “equitable” ownership. This means the person has the “benefits and burdens” of ownership without legal title. You might be able to clearly document the percentage that your son holds equitable title to. This may be sufficient. But it is risky because there is no actual legal title held and the IRS could readily argue that it fails to be a qualified ownership interest.