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Buying Rental Home from Parents

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s66

Junior Member
What is the name of your state (only U.S. law)? NE
I've been living in a home that my parents own and renting from them. I'm ready to move to another location, and they are old enough that they don't want to do a 1031 exchange for another rental property. I realize that they would be responsible for the capital gains tax when the house is sold, which is going to be about $40,000. My question is this: We've discussed the possibility that they would do a 1031 exchange on a house that I would select, then enter into an agreement with me so that I would pay them the purchase price of the new home in installments. Basically, it would be a seller financed deal, so they could spread out the gain (and getting interest payments from me in the process) over a period of time. Would there be any other way around the capital gains tax / does this seem like a smart option? I realize if the purchase price of the new home is less than the realized gain on the sale of the currently owned home, they would be responsible for the gain on that amount in the first year, but spreading out the gains tax in installments seems like a better option. Also, since most likely my debt to them will be longer than they will live, how would this agreement affect the probate situation(and any tax consequences) when that occurs? Thanks in advance.
 


LdiJ

Senior Member
What is the name of your state (only U.S. law)? NE
I've been living in a home that my parents own and renting from them. I'm ready to move to another location, and they are old enough that they don't want to do a 1031 exchange for another rental property. I realize that they would be responsible for the capital gains tax when the house is sold, which is going to be about $40,000. My question is this: We've discussed the possibility that they would do a 1031 exchange on a house that I would select, then enter into an agreement with me so that I would pay them the purchase price of the new home in installments. Basically, it would be a seller financed deal, so they could spread out the gain (and getting interest payments from me in the process) over a period of time. Would there be any other way around the capital gains tax / does this seem like a smart option? I realize if the purchase price of the new home is less than the realized gain on the sale of the currently owned home, they would be responsible for the gain on that amount in the first year, but spreading out the gains tax in installments seems like a better option. Also, since most likely my debt to them will be longer than they will live, how would this agreement affect the probate situation(and any tax consequences) when that occurs? Thanks in advance.
How much gain are you anticipating that they will have? Is the value of the home 40k or is that the anticipated gain?

Just as an FYI, Gain would be selling price minus selling costs, minus the original purchase price of the home plus any major improvements made. They are also going to have to recapture depreciation.
 
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s66

Junior Member
How much gain are you anticipating that they will have? Is the value of the home 40k or is that the anticipated gain?

Just as an FYI, Gain would be selling price minus selling costs, minus the original purchase price of the home plus any major improvements made. They are also going to have to recapture depreciation.
Thanks. They are telling me that the $40,000 is the anticipated gain (expected selling price minus adjusted basis - taking into account the things you mention e.g. closing costs, minus purchase price, plus improvements, etc.). They owned a rental prop years ago that appreciated, then sunk the proceeds of that sale into the current rental home with a 1031 exchange. They purchased the original property about 30 years ago, hence the $40,000 anticipated gain.
 

FlyingRon

Senior Member
What Ldij is telling you that your parents are likely to owe tax on the ENTIRE price of the house because they if they claim it was a rental, they should have been depreciating it which means that they get a tax deduction (that they should have taken, but it still needs recpature anyhow) that must be recaptured because houses don't really get "used up" and go down in value.

Of course if they weren't really charging a market rent, this thing isn't a rental business at all (while they might have been able to take certain deductions as a second home if they don't already have one, they can't take others).

Your parents should take their records to a tax advisor before doing anything (you'll really need one to do the 1031 exchange anyhow if that is warranted).

Your statements also don't make much sense. Depending on how the sale for you is set up, the sale either occurs all at once when it's entered into, or all at once when you finally pay it off. There's no "speading out" of the gain. Further, spreading out doesn't make a whole lot of sense, the rate (presuming the tax code doesn't change) will be the same.
 

davew128

Senior Member
Your statements also don't make much sense. Depending on how the sale for you is set up, the sale either occurs all at once when it's entered into, or all at once when you finally pay it off. There's no "speading out" of the gain. Further, spreading out doesn't make a whole lot of sense, the rate (presuming the tax code doesn't change) will be the same.
OP is referring to an installment sale, which would spread out the gain (less the depreciation recapture which is recognized in year 1) over the life of the loan. On the flip side, I would be concerned about a gift loan here and properly reporting that.
 

s66

Junior Member
OP is referring to an installment sale, which would spread out the gain (less the depreciation recapture which is recognized in year 1) over the life of the loan. On the flip side, I would be concerned about a gift loan here and properly reporting that.
Yes, I am talking about an installment sale. The payments (whether monthly or yearly) would include interest (same as current mortgage rates or at least the AFR rate).
 

LdiJ

Senior Member
Yes, I am talking about an installment sale. The payments (whether monthly or yearly) would include interest (same as current mortgage rates or at least the AFR rate).
I definitely think that your parents need to be consulting with a tax professional with all of the details in hand, before doing anything at all.
 

Just Blue

Senior Member
I'm going to slightly disagree with the others. I "think" you and parents should consult with both a Real Estate Attorney and a CPA.
 

LdiJ

Senior Member
I'm going to slightly disagree with the others. I "think" you and parents should consult with both a Real Estate Attorney and a CPA.
The OP is not going to have any tax consequences from the kind of transactions he/she is batting around...and I am not sure that a real estate attorney is going to be of much help either until its established what is the best method to handle things from a tax perspective. I would certainly agree that having a real estate attorney draw up the paperwork once its established that what is being proposed is realistic/wise from a tax standpoint.

The biggest problem is that this property is likely fully depreciated. Therefore the bigger tax burden is going to be the depreciation recapture, (at ordinary marginal tax rates).

In all reality, its quite possible that the better choice for his parents would be to rent the property to someone else once he moves out, rather than disposing of it at all.

Of course, if the OP would care to disclose the actual value of the property as opposed to its potential capital gain, that could dramatically change the advice. If mom and dad paid 20k for the property 30 years ago and its worth 60k now, that is a whole lot different than if mom and dad paid 200k for the property 30 years ago and its worth 240k now.
 

s66

Junior Member
The OP is not going to have any tax consequences from the kind of transactions he/she is batting around...and I am not sure that a real estate attorney is going to be of much help either until its established what is the best method to handle things from a tax perspective. I would certainly agree that having a real estate attorney draw up the paperwork once its established that what is being proposed is realistic/wise from a tax standpoint.

The biggest problem is that this property is likely fully depreciated. Therefore the bigger tax burden is going to be the depreciation recapture, (at ordinary marginal tax rates).

In all reality, its quite possible that the better choice for his parents would be to rent the property to someone else once he moves out, rather than disposing of it at all.

Of course, if the OP would care to disclose the actual value of the property as opposed to its potential capital gain, that could dramatically change the advice. If mom and dad paid 20k for the property 30 years ago and its worth 60k now, that is a whole lot different than if mom and dad paid 200k for the property 30 years ago and its worth 240k now.
Thanks. I can disclose the info. you mention. The first house was purchased about 30 years ago for $55,000. They sold that approx. 7 years ago for $220,000, and reinvested the $220K and another 65K for the current home (they did a 1031 exchange then). The expected value of it is around 300K right now. They visited an accountant, who informed them that they probable cap. gains tax on a sale of approx. 300K would be 40K. Does that help? Renting is an option for them, but as I mentioned in my first post, they are getting older and don't want to deal with that. They don't have to deal with much now because I do any maintenance on the house. It's just become too much house for me to maintain - and I want to downsize if possible, but I'm not crazy about them taking a 40K hit.
 

LdiJ

Senior Member
Thanks. I can disclose the info. you mention. The first house was purchased about 30 years ago for $55,000. They sold that approx. 7 years ago for $220,000, and reinvested the $220K and another 65K for the current home (they did a 1031 exchange then). The expected value of it is around 300K right now. They visited an accountant, who informed them that they probable cap. gains tax on a sale of approx. 300K would be 40K. Does that help? Renting is an option for them, but as I mentioned in my first post, they are getting older and don't want to deal with that. They don't have to deal with much now because I do any maintenance on the house. It's just become too much house for me to maintain - and I want to downsize if possible, but I'm not crazy about them taking a 40K hit.
Ok, there is a LOT more capital gain than what you imagine. There is the capital gain from the sale of the original property which was deferred by the 1031 exchange...plus the capital gain from the current property. So the capital gain is more in the neighborhood of 200k rather than 40k. Plus there is going to be almost 55k in deferred depreciation recapture from the original property, as well as 7 years worth of depreciation recapture from this property, which is all taxed at their marginal tax rate. All in all, your parents are going to pay a serious bundle in tax. I would guess that the amount of tax itself could hit 60k or better, depending on their marginal tax bracket.

Unless they, NOT YOU, are in need of the cash, they would be far better off getting a property manager to handle the business of getting them another tenant and maintaining the rental property.
 

s66

Junior Member
Ok, there is a LOT more capital gain than what you imagine. There is the capital gain from the sale of the original property which was deferred by the 1031 exchange...plus the capital gain from the current property. So the capital gain is more in the neighborhood of 200k rather than 40k. Plus there is going to be almost 55k in deferred depreciation recapture from the original property, as well as 7 years worth of depreciation recapture from this property, which is all taxed at their marginal tax rate. All in all, your parents are going to pay a serious bundle in tax. I would guess that the amount of tax itself could hit 60k or better, depending on their marginal tax bracket.

Unless they, NOT YOU, are in need of the cash, they would be far better off getting a property manager to handle the business of getting them another tenant and maintaining the rental property.
Thanks. I suppose the other option is to do another 1031 exchange and I continue to rent from them, or just continue to rent more house than I can handle. For 60K, we could hire a maid. Thanks for all the help.
 

davew128

Senior Member
The depreciation recapture rate tops out at 25% not ordinary rates. s66, I'm not sure why you're looking at the tax hit, its there's not yours.
 

LdiJ

Senior Member
The depreciation recapture rate tops out at 25% not ordinary rates. s66, I'm not sure why you're looking at the tax hit, its there's not yours.
Dave, google does give that info as a header, but its completely wrong.

http://www.irs.gov/publications/p544/ch03.html#en_US_2013_publink100072560
 

davew128

Senior Member
Dave, google does give that info as a header, but its completely wrong.

http://www.irs.gov/publications/p544/ch03.html#en_US_2013_publink100072560
I didn't use google, I used IRC 1250, you know, the code section that applies to recapture of depreciation on REAL property not PERSONAL. I mean its only been around in its current form since 1997...:rolleyes:
 

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