Rental for your kid offers slight tax benefits

James Hamill for the ABQ Journal writes: Historically, real-estate rentals were one of the top tax shelters on the market. Mortgage interest and depreciation tended to create losses that saved current tax dollars, and there were no restrictions on claiming these losses.

And even better, the property would generally increase in value, so that annual tax losses would be accompanied by accrual of economic gains. Finally, when the property was sold, the gains were taxed at favorable capital-gains tax rates.

Perhaps the only impediment to use of this strategy was the fear that the tenant would be bothersome or would even trash the property. But what if the tenant could be your own flesh and blood?

When I was working in Phoenix about 30 years ago, clever condo developers in Tempe would advertise to parents of Arizona State University students, and even send promotional material to the parents’ home.

The idea was to buy a condo and rent it to your child. This made it a rental property and the parent could save tax dollars with deductions for interest and taxes, insurance and maintenance, and even depreciate the cost of the condo.
Developers are not, however, tax experts, and this idea had problems. First, the tax law does not allow a reported loss when the property is used by a family member, unless the use is as a principal residence and fair market rent is paid.

No problem said the non-tax-expert developer. Mom and Dad will simply gift money to the child, who will then pay the fair rent to the parent. But the legislative history of the tax provision said that gifts from the owner must be considered in determining whether fair rent was paid.

Thirty years ago mortgage interest rates were above 13 percent and rentals could be depreciated over 15 years. So big tax losses, and big tax savings, were not hard to come by.

Now interest rates are under 5 percent and rentals are depreciated over 27.5 years. So many real-estate rentals produce net income on the landlord’s tax return. Renting to the child is not much of a tax shelter.

But it can still be an attractive tax and economic deal, but now with no gift and just asking the child to pay what she can.

Let’s say that Mom and Dad buy a house to be used by their adult daughter. Interest is $6,000 per year, taxes $2,000, insurance and maintenance $2,000, and depreciation $5,000-$15,000 total expenses.

Fair rent is $15,000 per year. The daughter pays $9,000 from her own funds. The daughter’s below-market rent use is personal use by the parent and no tax loss is allowed.
Someone tells Mom and Dad to give the daughter $6,000 a year so she can pay the fair rent of $15,000. They do so. They treat this as a “regular” rental. They show $15,000 of rent and $15,000 of expense. No loss, but $7,000 of expenses deducted that would not be allowed if it is their personal property,

But what if there is no gift? There is $9,000 of rent income. The tax law allows $9,000 of expenses. Interest and taxes are claimed first. That leaves only $1,000, which the law says is from the insurance and maintenance.

Now what’s better? The “rental” inflates the gross income with the gifted funds, but still shows zero net income because the low current interest rates and slower depreciation leads to that result. The “no rental” also shows less gross rent but zero income because the tax law prevents a loss.

But the rental also reduces the tax basis of the property by $5,000 of reported depreciation. The parents inflated rent income with their own gifted funds, and then offset that income with depreciation.

But they still ended up with no tax loss, but with $5,000 of future tax gain caused by depreciation they did not need.

Renting to your child is not a bad idea, but our current economic and tax world suggests just charging what the child can pay and not making circular gifts to make the property look like a “real” rental. This may actually save tax dollars and avoid questions about the source of rent payments.