Can we claim $500K tax break if renting to tenants?

Couple learns tax implications of selling primary home, rental

By Robert J. Bruss
Inman News

DEAR BOB: We have rented out a legal apartment in our primary residence for 17 years. My wife and I intend to sell our house and shelter $500,000 of our gain. In order to do so, must we be "tenant free" for 24 of the last 60 months? --Bruce C.

DEAR BRUCE: No. You can sell your principal residence with the tenant still living in the apartment.

For capital gains tax purposes you will be making two sales. One is the sale price of your principal-residence portion. The other sale is the sales price of the rental apartment.

But the Internal Revenue Code 121 principal-residence-sale tax exemption up to $500,000 for a qualified married couple (up to $250,000 for a single home seller) applies only to your capital gain profit on the principal-residence portion. That's presuming you both occupied your primary residence at least 24 of the last 60 months before the sale.

The capital gain on the sale of the rental apartment has two components. One is the "recapture" tax at the special federal tax rate of 25 percent for the depreciation you deducted after May 6, 1997. The other part of the capital gain on the rental apartment is taxed at a maximum federal tax rate of 15 percent. For full details, please consult your tax adviser.

EVICT TENANTS IF YOU FEEL STRONGLY ABOUT THEIR BREACH OF LEASE

DEAR BOB: What recourse do I have when my rental tenants don't honor the terms of their lease? The house they rent from me has a nice yard. The lease terms require them to maintain the property. But the trees look like they are dying. I asked my tenants to water the trees, but they say they don't have time. What are my options to have them honor their agreement to maintain the property? --Lisa D.

DEAR LISA: Even if your tenants have a lease, if it requires them to maintain the yard and they fail to do so, you can evict them if you feel strongly about their breach of the lease terms.

Just follow the state unlawful detainer (eviction) procedure, such as delivering a "Notice to Quit" and then filing the court lawsuit. If this is your first eviction, I suggest you hire a local attorney who specializes in evictions so you can learn how it is done.

If the lease is about to expire and you don't want to evict, you have another alternative. It is to substantially raise the rent (presuming no rent-control limit applies). The tenants will then either move out or you will have the extra rent money to hire a gardener to keep the yard and trees looking good.

CHECK SPOUSE'S DEBTS BEFORE ADDING HER TO HOME TITLE

DEAR BOB: I want to add my spouse (not married) to my deed. We want to take advantage of that $500,000 tax break when I sell our home. But I want to be sure she has no liens before I do this. She had several loans with her ex-husband and then a bankruptcy. She went to our local courthouse and was told there were a couple of liens but it looks like they were cleared. How can I verify this before proceeding? --Harry G.

DEAR HARRY: You say you want to add your spouse's name to your deed but you're not married. If she is not married to you, she is not your spouse.

The only way to be sure she doesn't have any liens that could attach to your home's title if you add her name is to obtain a new owner's title insurance policy. Before issuing such a policy, the title insurer will thoroughly check for possible judgments and other liens against her. Her informal search at the courthouse was a waste of time.

However, if you are legally married to her and you want to claim the Internal Revenue Code 121 principal-residence-sale tax exemption up to $500,000 (instead of $250,000 for a single home seller), her name does not have to be on the title. However, to qualify for the $500,000 exemption, you both must occupy your principal residence at least 24 of the last 60 months before its sale. For full details, please consult your tax adviser.

www.LagretRealEstate.com

It's not a gift, it's an investment

Family member seeks healthy return for help with down payment, mortgage

By Jack Guttentag
Inman News

Gifts of equity within the family are common. Parents often provide the down payment on their child's first home purchase. Many parents, however, can't afford a sizeable gift -- among other things, they may be concerned about the adequacy of their assets for retirement. Yet they might welcome an opportunity to help their children if it took the form of a reasonably safe investment yielding an adequate rate of return.

A house purchase by a family member may provide such an investment. Over the years, I have advised a number of families who asked me about how to set up a plan that would meet their particular needs. I even wrote a few articles describing such plans. On reading these articles now, however, I am not very pleased because they provide limited help when the individual circumstances differ from those in the article, as they often do.

Usually the investor contributes to the down payment, but some home buyers may need help with the monthly payment as well. In addition, sometimes the investor is a co-occupant, though not necessarily for half the house.

I have come to believe that there is a large untapped market for intrafamily investments in house purchases. The reason that so few actually materialize is that every deal is different, and designing it properly is very complicated. To remedy this, I have developed a spreadsheet that accommodates a wide variety of preferences of the home buyer and the investor.

The spreadsheet calculates the percent of the home equity (property value less mortgage balance) that is owned by each party at the end of each year. The respective ownership shares depend on the amount they each contribute to the initial cost of the home, the amount they each contribute monthly, the rent that is credited to the investor, and the interest rate that is used to calculate the future value of each party's contributions, including the rent credit.

The spreadsheet has two purposes. First, it is a simulation tool that allows the buyer and investor to see how each will fare under alternative combinations of interest rate, rent credit, investor contribution and property appreciation rate. They can try different scenarios to find the one that leaves them both satisfied.

Second, the spreadsheet provides the accounting record of where the parties stand at any point in time. They can watch their equity shares change over time, and can use the simulation capacity to forecast what they will be in the future.

The spreadsheet is a tool, not a contract. To use the tool effectively, the parties should have a contract that addresses four major issues.

Rent Credit: The parties must agree on the rent payment credited each month to the investor. The rent credit ought to approximate what the home could be rented for in the market, net of taxes, insurance, utilities and routine maintenance, all of which the occupant should pay. If both parties are occupants, the rent credit disappears or, if they occupy different amounts of space, is scaled down.

In addition, there must be agreement on how often the rent will be adjusted, and how. One possibility is to adjust the rent credit every year in line with changes in the rental component of the Consumer Price Index.

Interest Rate: The parties must agree on the interest rate used to calculate the future value of the contributions. The rate should approximate what the investor could earn if the funds were placed in investments of comparable risk. In many cases, the mortgage rate might serve quite well as the investment rate.

Property Improvements: Because of the potential for conflict, it is useful for the parties to agree beforehand on how improvements are to be handled. The spreadsheet treats expenditures on improvements in the same manner as other payments, recording a credit to the party making the expenditure. However, investors and occupants won't necessarily have the same interest in an improvement. For example, the occupant might want a swimming pool, which might add little to the value of the property.

One approach would be to reduce the credit on improvements initiated and paid for by the occupant using a credit schedule based on general experience. For example, an added bedroom might be a 100 percent credit while a swimming pool might come in at 40 percent.

Termination: Most investors, even within the family, want to terminate the deal and get their money after 5-10 years, so a termination provision needs to be included. Assuming the buyer has not sold the house before the termination date, the investor must be paid off. This may require the buyer to do a cash-out refinance based on the equity remaining after the investor has been paid off.