If your child will be entering or returning to college this fall, he or she may prefer off-campus housing to living in a dorm. At the same time, you could be looking to acquire real estate property for the investment and tax benefits.
Fortunately, there’s a way you can kill two birds with one stone.
Strategy: Buy real estate property near the school and rent a unit to your child. For your child, this provides housing at a reasonable cost from a known landlord. For you, it’s a real estate tax shelter that might appreciate in value.
With this arrangement, you can even write off the cost of visiting your child at college. When you eventually sell the property, most of the gain will be favorably taxed capital gain. For 2012, the maximum federal tax rate for long-term capital gain is 15% (scheduled to increase to 20% in 2013). The maximum federal rate on gain attributable to depreciation deductions is 25%.
Offset rental income
Don’t put things off if this strategy meets your needs. If you have not done so already, start your search before the fall semester begins.
As with other rental real estate investments, the rent you receive from your tenants, including your child, is subject to income tax. But you can offset the taxable income with deductions for mortgage interest, property taxes, maintenance, insurance, etc., as well as claiming depreciation deductions based on the property’s purchase price. (It takes 27.5 years to fully recover the cost of residential rental real estate.)
Best of all, you may be able to use losses from the rental activity to shelter highly taxed ordinary income (see box below).
Get in touch with a PAL
Also, be aware of a potential tax trap if you end up claiming a loss. Under the rules for “passive activities,” your deductions from rental activities generally can’t be more than the amount of your annual passive income from the activities.
Key exception: Under a special tax law provision, you can use passive activity losses (PALs) to offset up to $25,000 of rental real estate income if you actively participate in the rental activity. In other words, you makedecisions, lease the units to other tenants, supervise the repairs and so on.
But be aware that this exception for PALs phases out for an adjusted gross income (AGI) between $100,000 and $150,000. It disappears completely once your AGI exceeds $150,000.
How to structure the tax benefits
Let’s say you bought a two-family house located a few blocks from campus for $300,000 (excluding the cost of land) in January. The first-year depreciation write-off is $10,455 under the depreciation tables. Also, suppose you have $15,000 in other deductible expenses on the house in the first year.
Because the going rent in the neighborhood is $800 a month, you receive $19,200 in rental income for the two units ($800 per month × 12 months × 2 units). Half of the money goes from one of your pockets into the other.
On these facts, you’re showing a $6,255 loss ($25,455 – $19,200) that you can use to offset other highly taxed income on your tax return. This assumes that your rental loss is not limited by the tax rules for PALs.
Tip: If you need to inspect the premises or have some other minor work done, combine the trip with a visit to your child. You can deduct the travel costs as long as the primary purpose for the trip is to handle real estate matters.
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