Q: How can I minimize my family’s taxes? They have a rental property and own it without a mortgage. They want to sell it to me.
Here’s the problem: They want the money as a lump sum rather than a monthly payment. They also don’t want to do a 1031 exchange with another rental property. In the future, they will probably use the money to buy themselves a new home.
I plan to renovate the house and use it as my primary residence. The home has gained nearly $200,000 in value since it was first purchased. I have enough money for a 20% down payment, but not enough to buy it all in cash. Is there a way to minimize capital gains taxes for this transaction?
What if they add me to the deed and I get a mortgage to help them buy a new home when they decide where they want to live?
A: How do you minimize taxes and make money from a rental property? These are key questions for real estate investors.
The Internal Revenue Service (IRS) generally allows real estate investors to defer paying taxes on the sale of a property owned for investment purposes as long as the investor purchases a similar type of property within 180 days of the sale of the existing property.
This type of exchange is called a 1031 exchange and has various other technical rules. But you said your parents didn’t want to do a 1031 exchange. And the 1031 rules probably won’t allow the house to be sold to you because you’re related to your parents.
A second option for your parents is to sell the house to you in installments. This will allow them to pay taxes on the gain from the sale over time. However, this won’t work if your parents want to sell the property directly to you.
While this may not be on the table, your parents can move back into the home for two years and claim it as their primary residence. This will allow them to keep up to $500,000 of their profits tax-free, but they will still have to pay back the depreciation they took and will only receive a portion of the $500,000 tax deduction. After that you can buy from them.
How you decide to use the property has no bearing on how much your parents will owe the federal government in taxes when the sale closes. How much your parents may or may not owe depends on a number of factors.
First, has the house actually increased in value net of expenses? You stated that it would sell for $200,000 more than your family paid for it. Your parents will likely have to pay capital gains tax on this value unless they make significant structural or material improvements to the property. Currently the maximum capital gains range is 20%. They may have to pay a 3.8% Medicaid surtax on this appreciation for a total tax of 23.8%.
On top of this, there is also depreciation clawback. Assuming your parents depreciated the property while they owned it, the IRS will require them to repay that depreciation at 25%.
In addition to these federal taxes, there may also be state taxes. Therefore, your parents may face a large tax bill when they sell the house to you. Because we don’t know the details of how much was spent, we can’t estimate the taxes they’ll owe. Your parents should meet with an estate planning attorney, tax planning professional, or registered agent to understand their options.
It is possible that they have invested so much money in the property over the years that they will have little or no tax to pay when they sell the home to you. Or they may have owned the property so long and invested so little that their tax bill could equal a third or more of the sale proceeds.
Now let’s consider your idea of adding your name to the deed and then getting a loan in your name to help your family buy their new home. If you consider yourself the owner of the home, consider that the IRS may view this transaction as a gift or sale.
Putting yourself in the title of the house can make things even more complicated for everyone. And I’ll give you a huge tax bill.
Your best move is to work with your family and a tax professional to discuss all available options. Good luck.
(Ilyce Glink is the author of “100 Questions the First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, a financial health technology company. Samuel J. Tamkin is a Chicago-based real estate agent attorney. Contact Ilyce and Sam through the ThinkGlink.com website.)