Adult children living in taxpayer's second home

[Penelope]

Rather than buy a home and rent it to his child and her husband (completing Sch E and taking all relevant deductions)--a high income taxpayer wonders if he can simply buy a home, take the interest and real estate deductions on Sch A on the second home, and provide rent-free living space for his child.

Is this arrangement prohibited? The taxpayer would never live in the second home.

Thank you.

[winnie]

tax book pg 4-11

The above reference backs up that you can deduct interest on a first and second home. The taxpayer is using that second home for personal purposes regardless of if he lives there, so I don't see any problems at all. Of course, you can't deduct interest on a third home. You have to prorate points paid over the life of the mortgage, not in first year, on a second home.

I currently have a taxpayer who has provided a home for her parents to live in for a few years. My taxpayer deducts the interest and taxes and we are writing points off over the loan period. My taxpayer will sell the home when the parents don't need it anymore and will need to pay capital gains, since she never plans to live there.

[Koss]

This works

You described the taxpayer as high-income, so they will still need to be careful with various thresholds that involve the phase-out or limitation on itemized deductions, and of course, the three-letter acronym that everyone is tired of hearing about, AMT.

But the fact that the guy never lives there isn't a problem. Mortgage interest is deductible on Schedule A for your main home and a second home. A second home is just that--a second home that is used for personal purposes (not held for investment or used as a rental property).

Those lucky enough to own three homes actually get to select which home is the second home. Mortgage interest on the third home is not deductible.

Personal use of the property includes allowing immediate family to live there without paying rent.

Here's the text of IRC 163(h)(4)

(4) Other definitions and special rules
For purposes of this subsection—
(A) Qualified residence
(i) In general The term “qualified residence” means—
(I) the principal residence (within the meaning of section 121) of the taxpayer, and
(II) 1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A (d)(1)).

Before you freak out about the fact that your client won't be living there, remember that this is the Internal Revenue Code, and it's not written in English. The authors of this text were kind enough to remind us that "used by the taxpayer as a residence" doesn't mean "used by the taxpayer as a residence." It means something else, and that something else is found in IRC 280A(d)(1):

(d) Use as residence
(1) In general
For purposes of this section, a taxpayer uses a dwelling unit during the taxable year as a residence if he uses such unit (or portion thereof) for personal purposes for a number of days which exceeds the greater of—
(A) 14 days, or
(B) 10 percent of the number of days during such year for which such unit is rented at a fair rental.
For purposes of subparagraph (B), a unit shall not be treated as rented at a fair rental for any day for which it is used for personal purposes.

But before you freak out about the fact that he won't be using the house for even 14 days, remember that this part of the Internal Revenue Code isn't written in English, either. If you just keep reading, you find that the phrase "personal purposes" is defined in IRC 280A(d)(2):

(2) Personal use of unit
For purposes of this section, the taxpayer shall be deemed to have used a dwelling unit for personal purposes for a day if, for any part of such day, the unit is used—
(A) for personal purposes by the taxpayer or any other person who has an interest in such unit, or by any member of the family (as defined in section 267(c)(4)) of the taxpayer or such other person;
(B) by any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit (whether or not a rental is charged for the use of such other unit); or
(C) by any individual (other than an employee with respect to whose use section 119 applies), unless for such day the dwelling unit is rented for a rental which, under the facts and circumstances, is fair rental.

IRC 280A(d)(2)(C) appears to expand personal use to include use by literally anyone that the owner of the home authorizes to live there without paying rent. So you don't even have to worry about the formal definition of "any member of the family of the taxpayer."

If you're curious...

"Any member of the family of the taxpayer" doesn't mean "any member of the family of the taxpayer." It means something else, and that something else is found in IRC 267(c)(4).

IRC 267(c)(4) is the "related party transaction" definition of family members.

Burton M. Koss
koss@usakoss.net

[Penelope]

Thanks and now to analyze another alternative

Winnie -- Thank you for your detailed reply and how you are treating a similar situation. I wasn't sure whether taxpayer must LIVE in home to take the 2nd home interest deduction on Sch A.

The other alternative, as I understand it, is for the taxpayer to charge the child rent -- calculated at arm's length, market value, of course -- and report rental income and expenses (including maintenance and repairs, insurance, and straight line depreciation) on Sch E. Taxpayer would "gift" the child the money to pay the rent. Sounds like the gain would be taxable on the subsequent sale of the home under either scenario.

Any one have any comments on this alternative?

Thanks again.

Penelope

[Penelope]

Curious about AMT implications....Yes, they apply

Thank you for the answer and also for taking the time to shed some light on the obscure-- even opaque-- meanings within the Internal Revenue Code. All I can say is "Go Figure!"

I think I'm familiar with the usual AMT implications and yes this taxpayer is subject to AMT, as well as phase out of itemized deductions. He asked me if there would be any adverse effects on AMT of these alternatives, for planning purposes.

Off the top of my head, I don't see any, but maybe I'm missing something obvious.

Thank you!

Penelope

[Koss]

Comment

The rental arrangement might trigger the "related party transaction" rules... and those rules just happen to be found in IRC 267(c)(4) [LMAO]

I'm not sure I see any real benefit in pretending that it's a rental. I say pretending, because if the owner is gifting money to the tenant, it's not really a rental property; it's a zero sum game--or worse.

On the surface, it allows more deductions and expenses: maintenance, repairs, and depreciation. But now you have to report the rental income that isn't really there, and the depreciation will reduce the basis, and that will increase the taxable gain when it is sold.

And it might not fly. There is a bedrock principle used by the tax court that says that if a transaction has no economic substance, then it will disregarded as a sham.

If the principal purpose of a transaction is tax avoidance, it probably won't hold up.

BMK

[Penelope]

Don't want any tax shams

I don't think we will pursue this alternative, due to the possible interpretation by the IRS that it is a tax sham. Thanks for the warning.

Penelope