In the past, Small Business Tax Strategies has advised you about a tax technique for certain families. It may be used when aging parents live in a home that has appreciated in value, but they’re no longer reaping the full tax benefits of home ownership.
For instance, the parents may have paid off all or most of their mortgage, so their interest deductions are small or nonexistent. And they derive little tax savings from property taxes in their low tax bracket.
Strategy: You can arrange to buy your parents’ home at a reasonable price. Then you rent it back to them at the going rate.
This way, your parents don’t have to move and you can reap the tax benefits that are more valuable to you in your higher tax bracket. This technique isn’t for everyone, but here are three good reasons to consider it:
1. It puts cash into your parents’ hands without refinancing the home or taking out a home equity loan.
2. It allows them to shift funds into safer investments than the current real estate market.
3. They can take advantage of the $500,000 home-sale tax exclusion ($250,000 for single filers).
Once you take legal ownership of your parents’ home, you’re entitled to all of the tax perks for rental property. This includes write-offs for operating expenses—such as utilities, maintenance, repairs, insurance and supplies—and a big depreciation allowance (but you can’t depreciate the cost of the property apportioned to land).
To avoid gift-tax problems, you should pay a fair price for the home. The price should be supported by newspaper listings showing the prices of similar homes in the area.
Of course, you may not have enough cash on hand to buy the home, so you can set up an installment sale. Alternatively, your parents may “gift” part of the home. The gift-tax exclusion—$12,000 per year for one parent or $24,000 for both parents—can shelter the transfer.
What about estate taxes? If the last surviving parent dies before an installment note has been paid off, it will be included in his or her taxable estate. But there’s a method of seller financing that can avoid this result.
What to do: Use a self-canceling installment note (SCIN) to seal the deal. If the parent dies before the note is fully paid, the remainder is automatically canceled. Therefore, it has a zero value for estate-tax purposes.
Does this sound too good to be true? The IRS thinks so. Over the years, it has repeatedly challenged the validity of SCINs involving related parties. And it has won more than its fair share. But a recent case represented a significant victory for taxpayers (below).
It is important to structure an SCIN with terms similar to a commercial loan. And all the parties should comply with the payment terms.
Tip: For an SCIN to be valid, there must be a genuine expectation that the debt will be repaid.