Writing off your Relatives

THERE’S NO PLACE like home for your first tax-reducing investment, a truth to which all homeowners can attest. In fact, there may be no place like it for a subsequent investment.

Owning rental property allows you to deduct depreciation, maintenance, insurance and utility expenses (in addition to mortgage interest and real estate taxes) on your federal tax return, which can significantly reduce your year-end tax obligation.

And don’t worry about finding the right tenant. Recent tax law changes allow these expenses to be deducted even when your tenant is a family member. What a relief! Mom and Dad aren’t likely to knock a hole in the wall while installing six-foot stereo speakers, and even if one of your children might, you can probably keep things in line as long as you’re paying those tuition bills. Uncle Sam-the relative you love to hate-is offering some nice solutions to common family dilemmas and providing strong incentives for pursuing investment opportunities in real estate.

Consider Al Seligman, for example. He’s a single doctor in his late 30s who earns $90,000 a year. Despite a number of write-offs from owning his home and running his office, he still has a taxable income of $49,000 and a year-end tax obligation of $15,831. Al’s parents, a retired college professor and a homemaker, live modestly on about $25,000 a year of combined pension, social security (tax-free) and unearned income, and they pay about $1,000 a year in income taxes. They have owned their own home for many years (it’s now worth $100,000).

Al suggests that they sell their home (since they’re both over 55, the profits from this one-time sale are not taxable) and safely invest the $100,000 for themselves to earn at least $8,000 a year in interest after taxes. He offers to buy a condominium and rent it to them as their new residence.

Here’s how his offer works:

Al buys a $100,000 condo with $10,000 down and takes a 30-year, 12 percent mortgage on $90,000. Al’s yearly income and expenses from this property are as follows:



Rent income ($500/mo. x 12) $6,000



Mortgage

payment ($925/mo. x 12) ($11,100)



Taxes,

insurance $100/mo. x 12) ($1,200)



Maintenance,

repairs ($200/mo. x 12) ($2,400)



Annual

profit/loss before taxes ($8,700)



Does that look bleak? It looks even worse at the end of the year, when these figures are reported on the IRS’s Schedule E “Supplemental Income Schedule.” All of Al’s loss can be deducted except for the small amount of mortgage payment that is credited toward the principal of his loan (a little more than $300 the first year). He can also deduct the depreciation of his condo (but not the land or common areas). This $100,000 condo has been appraised at $90,000, the land and common areas at $10,000. It can be depreciated over 15 years using either an accelerated formula devised by the IRS (ACRS) or the “straight-line” method: deducting one-fifteenth (6.6 percent) of the cost each year for 15 years. The annual depreciation on a straight-line basis is $90,000 times 6.6 percent, which equals $6,000 per year. Al’s Schedule E looks like this:



Income $6,000

Expenses:

Interest ($10,800)

Taxes,

insurance ($1,200)

Maintenance,

repairs ($2,400)

Depreciation ($6,000)

Loss $14,400



This loss is deducted from his taxable income, reducing it from $49,000 to $34,600. The $15,831 in taxes he would have owed on $49,000 is reduced to an obligation of $9,043. This savings of $6,788, when subtracted from the annual before-tax loss of $8,700, results in an annual operating loss of only $1,912.

His parents, on the other hand, are earning at least $8,000 in interest and are paying only $6,000 in rent. His loss is exceeded by their gain-an excellent restructuring of the extended family’s income and tax bracket.

But Al’s loss is likely to be further exceeded by the rise in the value of the condo. Assuming his parents’ reasonable longevity, Al won’t sell for a few years. Therefore, the profit on his sale will be a long-term capital gain that will be taxed at a maximum rate of 20 percent in his high (50 percent) tax bracket. If, in five years, the value of the property has increased 10 percent per year, it can be sold for $161,000. At that time, Al will owe the bank $88,000 on his mortgage and $18,200 to the IRS in taxes on his long-term gain. He will have saved well over $30,000 in income taxes over the five years and will have put $54,800 in his pocket!

Too good to be true? Not at all. As Sezee Zeluff, a tax manager at Arthur Andersen & Co., says, “So long as his intent is to make a profit and he is charging his parents a ’fair market’ rent, Dr. Seligman’s investment is legitimate. The ’safe harbor’ provision presumes a profit motive if the taxpayer experiences at least two years of profit in five. But his profit motive can still be established even if this two-year rule is not met. Since real estate investments frequently are made for appreciation potential rather than for operating profits, the doctor may have difficulty showing two years of profits. However, his capital gain in the fifth year will create at least one year of profit.”

Other family situations also invite serious consideration of rental property investments. Increasingly, parents are weighing the cost of dormitory housing against the cost of buying an apartment or condominium to house their children while they attend college.

The same investment in a $100,000 condo like Al’s made by a married couple filing jointly with a taxable income of $100,000 results in a yearly operating cost of about $1,500 (at $167 a month over nine months, it’s equal to most dormitory rates). And they, too, can pocket more than $50,000 in net capital gains at the end of five years.

Even for a couple in a lower tax bracket with half that taxable income, the operating cost is under $3,000 per year, and the net after-tax profit on the gain from the sale is close to $60,000. So if they can afford the slightly-higher-than-dorm-fee costs for those five years, they’re in line for even heftier savings. Consiaering that the resale value of rental property in college towns is typically high, all parents of college-bound children should explore these opportunities.

One caveat: For parents to start giving their child a monthly allowance to cover the rent after they purchase the property presents two financial and legal problems. First, the rental money coming to the parents each month would be doubly taxed-once as it came to them from their paycheck and again as it comes back to them as rental income. Also, as Zeluff points out, “The IRS’s concept of an ’arm’s length’ transaction [a fair rental] is questioned when it appears you are giving a relative the cash to pay the rent. Even if the child is financially dependent, he or she should have independent funds to cover the monthly rent. A part-time job, a personal savings account-even if the money was previously provided by a parent-or a trust fund could be used to support the rental obligation.”

In general, real estate is considered to be a good moderate-risk investment. For a small amount of cash, you can own a tangible piece of property of significant value and income-generating potential. Ownership can reduce your taxes, and real estate is likely to appreciate in value, making it a good choice for mid- to long-term gains.

Any investment of this size should bemade carefully. A prospective buyer shouldseriously study the market and add to theanalysis the “intangible benefits” inherentin solving problems of family living situations. With the right choice of property, youcan reap many tax benefits-and look forwar to that fat envelope.