Q: How do I minimize taxes for my parents? They have a rental property and own it without a mortgage. They want to sell it to me.
Here’s the problem: They want the money as a lump sum instead of monthly payments. They also don’t want to undertake a 1031 exchange for another rental property. They will likely use the money to buy a new home for themselves in the future.
I intend to renovate the house and use it as my primary residence. The house has appreciated about $200,000 since they first purchased it. I have enough for 20% down, but not enough to buy it all cash. Is there a way to minimize capital gain taxes for this transaction?
What if they add me to the deed and I take out a home equity loan to help them purchase a new house when they figure out where they want to live?
A: How do you minimize taxes and get money out of a rental property? Those are key questions for real estate investors.
The Internal Revenue Service (IRS) generally allows real estate investors to defer paying taxes on the sale of a property owned for investment purposes, provided the investor buys what’s known as a like-kind property within 180 days of selling the existing property.
This type of exchange is called a 1031 exchange and has various other technical rules. But you’ve mentioned that your parents don’t want to do a 1031 exchange. And, the 1031 rules likely would not allow the sale of the home to you, as you are related to your parents.
A second option for your parents is to sell the home to you on an installment basis. That will allow them to pay taxes on the gain from the sale over time. But this won’t work if your parents want to simply sell the property to you outright.
Although this doesn’t seem to be on the table, your parents could move back into the home for two years and claim it as their primary residence. That would allow them to keep up to $500,000 in profits tax-free, although they would still need to pay back the depreciation they took and may only get a portion of the $500,000 tax break. You could buy it from them after that.
How you decide to use the property isn’t relevant to what your parents will owe in taxes to the federal government when the sale closes. What your parents will or won’t owe depends on a number of factors.
First, has the home truly appreciated in value net of expenses? You indicated that it would sell for $200,000 more than your parents have paid. Your parents will likely have to pay capital gains taxes on that appreciation, unless they made significant structural or material improvements to the property. The top capital gains bracket at the moment is 20%. They might have to pay the Medicaid surtax of 3.8% for a total tax of 23.8% on that appreciation.
On top of this, there’s the depreciation recapture. Assuming your parents took depreciation on the property while they owned it, the IRS will require them to pay back that depreciation based on a rate of 25%.
In addition to these federal taxes, there may be state tax as well. That’s why your parents may face a sizable tax bill when they sell the home to you. Since we don’t know the specifics of what was spent, we can’t estimate any taxes they’ll owe. Your parents should sit down with an estate planning attorney, tax planning professional or enrolled agent to understand their options.
It’s possible that they put so much money into the property over the years that they’ll have little to no taxes to pay when they sell the home to you. Or, it may be that they have owned the property so long, and invested so little, that their tax bill will equal a third of the sales proceeds – or more.
Now let’s address your idea of simply adding your name to the title, then taking out a loan in your name to help your parents buy their replacement home. If you think of yourself as the owner of the home, consider that the IRS might view that transaction as either a gift or a sale.
Putting yourself on the title to the home could make things messier for everyone. And, give you a whopping tax bill down the line.
Your best move is to work with your parents and a tax professional to discuss all of the options available. Good luck.
(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, a financial wellness technology company. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.)
