Keeping real estate in the family
Unless kids hold ‘remainder’ interest, plan will work
DEAR BENNY: My wife and I plan to sell our home to our grown children for $400,000, which would be an all-cash deal, and we would remain in the home until we die. My wife and I would then pay all expenses in running the house, such as taxes, insurance, utilities, repairs, grass cutting, etc. Would this sale structure in any way affect the up-to-$500,000 capital gains exclusion my wife and I would be eligible for in executing this sale?
When my children eventually sell this house, will they still be subject to capital gains or losses as the case may be? –Frank
DEAR FRANK: That’s an excellent question and a very good proposal. But you have to be careful how you structure the sale.
If you and your wife have owned and lived in the house for at least two years out of the five years before the sale, and if you file a joint income tax return, you can exclude up to $500,000 of any profit you will make on the sale. If you file a separate tax return (or are a single taxpayer), then the exclusion is limited to $250,000.
But there’s a catch when dealing with family members. You cannot exclude gain from the sale of a remainder interest in your home to a related person, which is defined as brothers, sisters, children and grandchildren.
What’s a remainder interest? Technically, it means that someone has a future interest in an asset. For example, you execute a deed to your property, giving yourself a life estate, and on your death the house goes to a charity (or to your children). The charity (or your children) would have a future, or remainder, interest in your property.
So, if you were to do the example above, you would not be able to claim the exclusion of gain.
But that’s not what you are doing. You are selling your house outright to your children, presumably for full market value less any real estate commission you would normally pay if this were a sale to a stranger.
So, you can claim the exclusion of gain. However, I would have your attorney prepare a lease, whereby you and your wife would be tenants of your children. The terms of the lease are negotiable, and I see no reason why your plan would not work.
When your children sell the property, unless they have lived in it after your death, they would have to pay capital gains tax on their profit. If they buy it for $400,000, and many years later sell it for $600,000, their gain is $200,000 (excluding real estate commissions and other closing costs), and will have to pay the tax.
Although I suspect that the capital gains tax will be increased in the next few years; currently it is 15 percent. So in my example, your children would have to pay the Internal Revenue Service $30,000.
DEAR BENNY: I am a divorced woman who owns a home and have been living for the past two years with my boyfriend with whom I have a solid relationship. (Nevertheless, I do not care to marry again.) He pays the mortgage and future property taxes. I have considered including him in the deed so he can benefit from the property tax and mortgage interest deductions. I am unemployed and my future career plans are not grandiose.
I’d like to know if I should add my boyfriend to the deed and draw a legal contract in which it is stipulated that I would receive all proceeds upon the sale of the house except for the cost of repairs he has made to the home. He would, in turn, benefit from the tax deductions.
I would greatly appreciate if you could give me some advice as to this plan. –J.P.
DEAR J.P.: Good suggestion but it’s not that easy. Do you really want to add him to title on your house? Even with the written agreement you suggest, you run the risk that he could challenge the validity of that document and claim that he has an interest and is entitled to his share of the proceeds.
If, however, you still want to pursue this, and your boyfriend is added to the title, he should be able to deduct some of the real estate taxes that he pays.
However, should you (or he) ever be audited by the IRS, the agency may question why he is deducting all of the real estate tax when he does not own all of the property. For example, if he will own 50 percent of the house, the IRS may take the position that he can deduct only half of the taxes he pays.
As for the mortgage interest deduction, there are problems — especially because he is not legally obligated under the loan documents.
There are, however, cases that allow a non-owner to deduct the interest he or she pays. First, we must look to the regulations that have been promulgated by the IRS.
Regulation 1.163-1(b) reads as follows: “Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness.”
In August 2003, the U.S. Tax Court addressed this situation and denied the interest deduction. The petitioner bought a house for his mother and although he was not on the title nor was the mortgage loan in his name, he made the monthly loan payments.
He argued to the court that he was obligated to repay his mother and “that his failure to repay would result, upon his mother’s death, in a corresponding reduction in his testamentary share of his mother’s estate.”
The tax court rejected this argument. Based on the facts, the court determined that the petitioner was neither “directly liable on the note securing the mortgage on his mother’s house, nor (was) he a legal or equitable owner of the property.” (Montoya v. IRS, decided Aug. 5, 2003.)
What exactly is required to be an “equitable owner”? Our legal dictionary defines this as ownership by one who does not have legal title. For example, if you are under contract to buy a house, you have “equitable title” — i.e., an interest in the property.
Obviously, each case has to be decided on the specific facts presented to the court. In the Montoya case, the tax court determined that the son just did not have enough evidence to prove that he had some kind of ownership in his mother’s property.
Several years earlier, this same court did allow a couple to deduct the mortgage interest even though they were not on title to the property. In Uslu v. IRS, the following facts were presented to the court.
Uslu had filed for Chapter 7 bankruptcy relief and was not eligible to obtain a mortgage loan. His brother bought the house in which the only occupants were Uslu and his wife.
The loan was in the brother’s name only, but Uslu made all of the mortgage payments. He also made all of the repairs and improvements to the property. The brother signed a quitclaim deed conveying the property to Uslu, although this deed was never recorded on the land records.
The tax court found that Uslu’s mortgage payments “constituted payments on an indebtedness” and thus could be deducted for income tax purposes.
According to the court: “The court is satisfied, from all of the evidence presented, that petitioners (Uslu) have continuously treated the … property as if they were the owners, and that they exclusively held the benefits and burdens of ownership thereof.
“On this record, the court holds that petitioners established equitable and beneficial ownership of the (property), and they were liable to (the brother) in respect of the mortgage indebtedness.”
How do you meet the burden? Here are some suggestions:
1. Your boyfriend must continuously live in the property. To prove this, his driver’s license, voter registration and utility bills should be in his name at the property address.
2. You and your friend should enter into a written agreement, spelling out that he is fully obligated to make the mortgage payments on a timely basis, and that you reserve the right to evict him should he go into default; the agreement should specifically state that you recognize that your friend has an equitable interest in the property.
3. Your friend must be responsible for all maintenance and upkeep of the property.
4. You should prepare and sign a quitclaim deed, in recordable form, conveying a portion of the property to your boyfriend. This will not be recorded, but will be further evidence of your decision that this property is, in reality if not legally, partially owned by your friend.
There obviously are no guarantees, but if you follow the guidelines spelled out in the Uslu case, you have a chance of prevailing should the IRS challenge those deductions. And you may be able to do this without putting him on title.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to firstname.lastname@example.org.