Gifts to/from parents

[ccbrown]

What is the name of your state?What is the name of your state? My parents live in Montana, I live in Alaska, and my siblings live in Oregon and Idaho.

My parents recently decided to transfer ownership of their primary home to my two siblings and me. They wanted to do it while still living, and we wanted to get the house at a stepped-up basis, so they simply gifted the purchase money to us ($250,000) rather than gifting the house. We purchased the house at appraised value and my parents filed a gift tax return. My parents continue to live in the house, so they are renting it from us at market rates. We show the rental income on our tax returns. We have been gifting the rent back to them, so there is no net money transfer. To document the rent payments and return gifts, each of us children have simply been recording 1/3 of the "transactions" in memos to our tax files; we don't actually send checks back and forth each month. I have recently read several articles about gifts and renting to family members, and now have two concerns about this arrangement:

1. Does the IRS view either the gift to buy the house, or returning the rent in a gift as abuse?

2. Is the memo enough to demonstrate to the IRS that my parents are renting and we are gifting, or do we need to actually send the checks back and forth?

[Snipes5]

You are correct to be concerned.

As it is now, you have no documentation that any rent was received. They should be paying you the rent, and the gifting should be completely separate transactions. That is at a minimum.

You are running the risk that the IRS will view this as a tax-motivated arrangement, and disallow all rental expenses.

See an Enrolled Agent and discuss this in detail.

Snipes

[ccbrown]

I am not sure I understand your comment about "tax-motivated arrangement". It seems that there are many, many legal actions taken by people solely to reduce their tax exposure. Do you mean the IRS would view this as tax evasion?

For our current arrangement, taxes were not the main motivator. Depreciation and expenses are offset by rental income. The deal is quite money-neutral (tax included) from my parent's point of view. My brother's taxes actually went up because he doesn't itemize.

Can you give me an idea of which part of the arrangement is potentially not kosher (other than the "transaction" memo)? Is it the gift to purchase or the gifting back of rent? Both?


Thanks

[Snipes5]

It's the gifting of the rent. They are supposedly renting at fair market, but no money is changing hands.

It is also the fact that the transactions are not "clean" and separate, ie they pay you rent, and you separately gift them.

It won't be viewed as tax evasion, which is quite serious, rather as tax "avoidance", which is similar but not as serious.

Check with an attorney or EA to make sure this arrangement will stand up to IRS scrutiny.

Snipes

[abezon]

The problem is you are claiming depreciation and other rental expenses based on a purchase price of $250,000, but are not renting for a fair price. Renting to a family member at less than fair market value is considered personal use by the owner, not rental use. Expenses are limited to rental income and must be deducted on Schedule A as a miscellaneous deduction subject to 2% AGI minimum.

The IRS would view your parents' rent payments & your consistent gifting of the same amount back to them as a sham transaction and will disallow any rental expenses on Sch.E, if it catches you.

Why have them pay rent at all? Just have them maintain the home & pay the insurance premiums. (The expenses you're trying to take on Sch.E.) You get to deduct any property taxes you actually pay on Sch.A, and you don't have to worry about tracking/recapturing depreciation.

[ccbrown]

Thanks for your comments. Some follow-up questions:

1. We want to keep the house of probate. If my parents don't pay rent, won't the IRS find that they never completely gave up "possession and enjoyment" of the property, and therefore still own it? Or will the IRS just include the full date-of-death value of the home in their taxable estate?

2. In your view, if we keep the gift and rent transactions completely separate, will this solve the issue of a "sham transaction?"

3. Both you and Snipes5 have focused on the rental arrangement, and have not commented on the gift of the purchase money. Is this because you view that transaction as likely to be acceptable to the IRS?

I really appreciate the feedback.

[abezon]

1. If the house is titled in your name, it's not part of your parents' estate. The "possession & enjoyment" phrase is used when a person dies shortly after making a large gift. In that case, the value of the gift can be included in the gross estate. Unless your parents are in poor health, this is probably not an issue.

2. I don't care how separate you try to make it look, it's a sham. If you want to get around the sham transaction, rent the house to someone else and gift your parents $X per month while they live elsewhere. Otherwise you're just trying to generate a paper loss at tax time.

3. Yep.

4. If your parents were able to gift you $250,000 cash to buy a house, why couldn't they spend $500-2000 for an estate planner to help them set up living trusts & wills and a gifting program? They should just hire a pro & get the whole enchilada done properly. I'm sure there are all kinds of little facts that are necessary for their advisor to know to create the best estate plan for them.