The "first-time home buyers blues" is a familiar lament, but it's all the more poignant to me now that I've crooned it myself. Despite the fact that my wife and I earn above the national family income, we can't qualify for anything resembling the median priced house.
So, like so many other couples starting out, we had to be creative--and to ask our parents for help.
But instead of just hitting my wife's parents up for a loan, we asked them to join us as investors--that's where the creative part comes in. This investment in real estate would require, on their part, some cash up front plus monthly payments.
The monthly payments, however, would almost entirely be offset by the tax breaks inherent in the investment. Eventually, both parties would receive a healthy return on their investment. Most important, it would allow my wife and me to get into our first home.
A law passed in 1981 allows depreciation to be written off on real estate rented to relatives. Formerly, depreciation could be declared only when renting to non-relatives.
Interest, Depreciation This is, of course, in addition to the interest payment write-off. By co-buying a house with us--and renting their half to us--our parents could write off their half of the interest and one-half of the depreciation on the house. A recent ruling extended the depreciation period to 18 years.
So what happens? After an initial investment for the down payment, each party is now responsible for half of the monthly mortgage.
Our parents, however, charge us a monthly rent for the use of their half of the house, thereby reducing their monthly mortgage obligation. Whatever the amount the parents actually do contribute should roughly equal their monthly tax break.
For example, on the purchase of an $80,000 house with 5% down, each party puts up $2,000 plus their share of the closing costs. With an interest rate of 13%, payments for principal and interest would come to about $840 a month.
Add to this property tax and other obligations, and the monthly payments would hit about $1,000 a month.
Besides their half of the monthly payment--$500--the children also pay a rent of $300; this makes their total monthly payment $800. The parents make up the remainder--$200.
Though this represents only 20% of the monthly payment, this difference can (and did in our instance) make the difference in purchasing a home.
In turn, the parents can write off their half of the interest expense (something the children can do as well) which, in this example, comes to about $5,000 for the first year. Add to this $2,000 in depreciation expense figured on the straight-line method, and the parent's total deduction for the year is $7,200.
Assuming a 50% tax rate (this method of buying isn't as attractive if the parents are in a lower tax bracket) a tax savings of $3,600 for the year, or $300 a month, is realized. This actually results in a profit for the parents of $100 a month.
Unfortunately, this profit is put back into taxes since the $300 monthly rental payments must be claimed as income.
A few years down the road--perhaps after a predetermined time period has lapsed--the equity is split, either by selling the home, or by the children buying out the parents' share. The assumption is, of course, that the children will be in a better position to assume a mortgage on their own.
There are variations on this theme. An accelerated cost-recovery method of depreciation can be employed, for example. With the accelerated method (in which a larger portion of the depreciation write-off is realized early on, against the write-off later in the depreciation period) a smaller rent can be paid to start, and raised each year in correlation with the increase in tax obligation.
However, if the property is sold before the 18-year depreciation period ends, the difference in tax savings gained by employing the accelerated method is considered as regular income, rather than capital gains income, which is taxed at a preferable rate.
The biggest pitfall in renting to relatives is that a fair market rent must be paid. In this case, it would actually be half of a fair market rent.
Rent Market Value
Since the rent for half of the house in the above example is $300, the question is: Is $600 a month a fair market rent for the home? If not, the IRS will not allow the depreciation deduction.
However, any person renting out a property can reduce a rent by up to 20% if the renters assume responsibility for the upkeep of the property. That would make the effective monthly rate $720 ($600 + 20%)--which should easily qualify as a fair market rent.
To really find out if this method of purchasing a home is advantageous, an accountant should be consulted. But it does have its attraction for both parties.
For the children, it's an easier way of obtaining that elusive first home and for building equity. For the parents, it's an opportunity to invest in real estate without placing strangers into your valuable property. And, it's a relatively painless way to help out your offspring.