Do your aging parents live in a home that's soared in value? Chances are, they've paid off the house, so they're not claiming mortgage interest deductions anymore. Even if they still deduct mortgage interest, they're probably in a low tax bracket now, so those deductions don't do much good anyway.
Your parents may take the standard deduction rather than itemizing.
Advice: Buy your parents' home, and then lease it back to them at the going rate. That way, your parents can tap into their home equity without moving away, and you're able to reap the sweet tax benefits of rental-home ownership.
Generate rental-property deductions
That transaction puts much-needed cash into the parents' pockets. For starters, your parents may not owe any federal income tax on the sale. Tax laws allow married couples to avoid tax on up to $500,000 of home-sale gains on a principal residence. If only one parent is the seller, the maximum exclusion is $250,000.
To avoid gift-tax complications, you should pay a fair price for the home. Save newspaper listings supporting similarly priced homes.
As the home's legal owner, you're entitled to the tax benefits from owning rental property. Take deductions for operating expenses, such as utilities, maintenance, insurance, repairs and supplies. Moreover, when you visit the rental property—as well as your parents—you can write off some or all of the travel expenses.
You can also claim depreciation deductions for the home. But you can't write off the property's cost apportioned to land. So, you should obtain an appraisal allocating the price paid between the depreciable structure and the nondepreciable land. If you include furnishings and appliances, those items should be allocated, too. You can write off those objects over a shorter period.
All these deductions offset the rental income you'll receive from your parents, which reduces the tax you'll owe on the income.
The deductions might even exceed the rental income, generating a tax loss, even though your cash flow is break-even or positive. However, any tax loss is generally considered a passive loss.
If your adjusted gross income (AGI) is less than $100,000, you can generally deduct rental real estate passive losses of up to $25,000 per year. Once your AGI exceeds the $100,000 mark, your ability to deduct those rental losses is reduced, dwindling to zero when your AGI reaches $150,000.
If you can't deduct all the losses because of your high income, you can deduct suspended passive losses when the house is sold or when it starts producing positive taxable income.
Leave a paper trail
If you want to claim the tax benefits of owning investment property, your parents must pay you a fair rent. Good news for you: Courts have said landlords can reduce the fair market rent they charge by 20 percent when they rent to relatives. This is supposed to reflect the savings in maintenance and
However, if you set the rent too low, the IRS might say the rental is personal. In that case, the IRS might limit deductions to mortgage interest and property tax, the same as for the personal use of a vacation home.
To avoid problems, lay a paper trail to lock in your deductions. Sign an official lease with your parents, the same as you would with any other tenant.
Eventually, your parents won't be able to live in the house they once owned. Then you can sell it, rent it to another tenant or move in (see box below).
Tip: If you do move in and the house becomes your principal residence for at least two years, you can sell it and shelter another $250,000 or $500,000 worth of home-sale profits from federal income tax ... a true tax bonanza!
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