Idea Hare Brained or Good

[erchess]

A newsletter that I won't name sent me a free sample in March and I got around to reading it today. I want to sketch out one tax saving idea and get opinions on it. The idea is that if a well to do taxpayer's parents own their own home and any mortgage payments are more principal than interest, or they are no longer itemizing, then the two households have net tax savings if the child buys the parents' residence and rents it back to them for no more than 20% less than FRV. The article cites TC Memo 1983-411 to back up the assertion that this discount is allowed. The child then reports the rent as taxable income and reports the usual expenses including occasional visits to inspect the property in order to report little income or even a loss. The article says that if the parents want to buy furniture they gift the money to their child who buys it for them and depreciates the furniture.

Ok what say you ladies and gents? I'm inclined to think that the title of the newsletter should be Shifty Eyed Sam's Snake Oil Letter but I'd like to believe that's wrong. If the idea is a good one I have as clients a business woman and her elderly parents who clearly fit this model and if I advise this or pretty much anything else they will do it.

[joanmcq]

Is there a purpose to the transaction other than tax avoidance? Like you, I am extremely wary of these kinds of possibly sham transactions. Especially traveling to the house to 'check up on it's condition'. Is the main purpose to check on the house or check on/visit the parents? How far is the travel? Do you bring along the spouse & kids?

The discount at renting to family and/or friends is possible if the family member is expected to take better than normal care of the property.

It certainly isn't something I'd peddle to the masses!

[veritas]

Perhaps

the authors might look closely at IRC Section 7701(o) enacted in 2010.

[Gary2]

Define "well to do". The ability to deduct rental losses starts phasing out at $100K, and is totally phased out at $150K. How much income would the kids likely need to get a mortgage on a second home (assuming they have a first home)? Or would the parents hold the paper?

Doing this would also trade the stepped up basis on death for the current market value - which may or may not be a good deal, depending on how long they hold onto the house and what the real estate market does. And it's not a simple, dollar for dollar trade, because they'd also be subject to unrecaptured 1250 gain on the depreciated amount.

Of course, there are the usual issues about protecting the parents' right to live there - would they be better off keeping a life estate?

[erchess]

Reflections

In the case of my current clients there are no worries about the child pushing her parents out of the house against their will unless she sincerely believed the move to be in their best interests. However I would think that a legal contract giving lifetime right to rent the place at a 20% discount to its presumably changing FRV or even at simply 20% of current FRV would protect the parents' interest. Probably two lawyers from two different firms would need to be hired just to make SURE that the contract really says what the parties intend it to say.

The "true" purpose of the deal in the case of my clients would be for the daughter to transfer money to her parents to ensure there financial security in their last years. In the alternative this daughter will take out an additional loan on her business or her own home and pay off the parents' mortgage and gift them the max every year. She makes a good gross income but I am concerned both by her debt load and her costs of doing business. It this recession gets worse and what people can pay her in rent drops she will be hung out to dry because her interest rates will not drop at all and her other costs will drop more slowly than the rents.

[taxea]

I too have a problem with the travel to check on vs. visiting family issue. I wouldn't take the travel under this circumstance.
As for the furniture/depreciation/gift issue...the home owner can spend gift money any way he pleases...don't think that would be an issue.
I have a client that did exactly this however his parents pay him FMV..I would like to see the document (TC Memo 1983-411) that indicates that it is okay to charge 20% less than FMV. I don't buy that one.

[erchess]

further reflections

I think I agree with not taking the travel but the point is moot for my client because the daughter's business literally adjoins the property on which the parents reside. So the trip is commuting mileage and besides she does not keep records and she makes personal stops.

Taxea the full cite is L. A. Bindseil, TC Memo 1983-411. According to the article the rationale for the lower rent is that due to relationship with the tenant rental expenses will be less because the tenant will take good care of the property.

Am I right in sensing consensus that the basic idea with a definite disagreement on taking the mileage and a possible quibble about taking less than FRV people believe the basic idea might fly?

[Roberts]

Jmo

While I'm sure this strategy would work, it's never something I would suggest a client utilize. Once you enter money into the relationship, it's going to change and the odds of this imploding are greater than anyone admits.

1. what if little Suzy is a meth addict and nobody told you because she just went through rehab for the 6th time and mom and dad are sure she's clean finally.
2. what if little Suzy puts her new husband on the title (contrary to the parents demands) and then is divorced a year later? Woops.
3. what if little Suzy gets upset that her parents aren't keeping up her new property to her satisfaction?
4. what if little Suzy takes out a home equity loan on the property (it's hers now right?) and blows it all in Vegas before filing bankruptcy?

It just seems ripe for a major blowup in your face for very little gain.

[Gary2]

At a minimum, I'd investigate whether a reverse mortgage would be a better strategy.

I'd also want to know if this implicitly establishes a life estate (a question of local law). If so, then it's a sale of a remainder interest to a relative, which I think loses the capital gains exclusion.

[Burke]

At a minimum, I'd investigate whether a reverse mortgage would be a better strategy.

I'd also want to know if this implicitly establishes a life estate (a question of local law). If so, then it's a sale of a remainder interest to a relative, which I think loses the capital gains exclusion.

Very good points. It seems to have all the earmarks of a life estate for the parents, which can be implied by actions, facts and circumstances, especially with a "lifetime" lease. While anything can happen, the most likely scenario is that one parent will pre-decease the other, dropping their income and ability to pay rent. I fail to see the advantage in this transaction if the daughter cannot take a loss. Plus when she sells the property it will be a capital gain rather than a (presumably) tax-free inheritance.

[taxea]

Thanks E...I am going to try and find out how they justify a 20% discount on the rent as allowable.

I would consider this a personal use until the TP provided a document from the IRS that allows a 20% deduction on FMV of rent. To my mind they should only be taking the mortgage interest and the property tax on Sch A. Regardless of whether the "renter" is related or not.

I will post if I am able to get a response.

[WhiteOleander]

While I'm sure this strategy would work, it's never something I would suggest a client utilize. Once you enter money into the relationship, it's going to change and the odds of this imploding are greater than anyone admits.

1. what if little Suzy is a meth addict and nobody told you because she just went through rehab for the 6th time and mom and dad are sure she's clean finally.
2. what if little Suzy puts her new husband on the title (contrary to the parents demands) and then is divorced a year later? Woops.
3. what if little Suzy gets upset that her parents aren't keeping up her new property to her satisfaction?
4. what if little Suzy takes out a home equity loan on the property (it's hers now right?) and blows it all in Vegas before filing bankruptcy?

It just seems ripe for a major blowup in your face for very little gain.

Even if the family gets along and none of the above issues happen, this idea could prove to be a bad one. If the daughter buys the house and later gets sued for some reason, the parents house could be taken to satisfy the judgement. Then she has no house and the parents have no where to live. They really need to go see an attorney.

[joanmcq]

I think the gist of the responses is not if it can be done (structured correctly, it CAN be done) but whether it SHOULD be done. As outlined by many others, there are many, many issues with transactions like this.

Also, the 20% discount isn't set in stone. I believe the case allowed an up to 20% discount, and was based on facts and circumstances, like so much else in tax law. It's the subleties that a newsletter blast isn't going to be able to go into. A strategy like this isn't one size fits all. It's not something I would recommend, unless, for example, the parents needed money, the house was a good investment, they wanted to 'keep it in the family', no siblings to squabble over their possible inheritance, etc. And I certainly wouldn't promote it as a 'great tax strategy'. If it makes sense for reasons other than tax (and other than impoverishing the parents for Medicaid), it could be something to look at.

[erchess]

TY all of you

I got an idea from somewhere (this time a newsletter) and benefited greatly from talking about it here before taking it to a client or in this case not taking it to a client.