Junior is about to start college this fall and will live in the dorm. But next year, based on his desires and school requirements, he’ll be living off-campus. You’ve looked at what the slum-lords charge for rent and you’re not at all happy about paying it. Maybe you should just buy a condo and hold an asset instead of handing your money over to someone else. It might be worth it. You’ll also need to upgrade your tax Zen. Here are some ways you could handle the condo.
Treat the Condo as Your Second Residence
If Junior lives in the house, you can treat it as a secondary residence. Like a Primary Residence, you can deduct interest and property taxes. But there are limitations.
- You can only deduct interest on up to $750,000 of combined mortgage balances. So, if you’ve spent a lot on your dream home, you might not be able to deduct any mortgage interest
- You are limited to a combined $10,000 in State and Local Taxes (SALT). You may not have any property taxes associated with a condo, but you might with a townhome. If you’re pushing up against the $10,000 limit already, the property tax deduction will likely only make a difference on your state taxes. This would be the case if your combined property taxes added up to $10,000 or more. Since you can’t deduct state income taxes from your state taxable income, the increased property taxes might be deductible on your state return.
Rent the Condo to Junior
Renting to family members tricky business. To start with, you need to rent to Junior at Fair Market Value (FMV) or at a slightly lower amount due to a good tenant discount. If you don’t rent at FMV, the IRS says you don’t have a profit motive and your expenses are only deductible up to the amount of rent received (remaining interest and taxes might be itemized deductions).
In order to treat the condo as a legitimate rental, it needs to be Junior’s primary residence. If he spends three months at home during the summer, that could jeopardize the status of the condo.
Finally, the rent needs to come from Junior’s income not from money you gift to him. If you gift money to Junior so that he can pay the rent, the IRS considers that a scam and they’ll disallow the rental losses.
Treat a Portion of the Condo as Your Second Residence and Rent a Room(s) to Others
You can rent a portion of the property to a renter and if you rent at FMV that portion of the house is treated as a rental. The tricky part is determining what amount of your expenses are legitimate rental expenses. There are a few different ways.
Expenses limited to the rental area. Let’s say you paint the room you rent or add a second phone line for that room (first phone lines can’t be assigned to a renter). The full amount of the expense is a rental expense and fully deductible against rental income.
Expenses for the entire structure. You need to use a reasonable method to assign the expenses. You can pro-rate based on square footage. For example, if the room you rent comprises 10% of the total square footage, 10% of your mortgage interest is deductible as a rental expense (the other 90% should qualify as an itemized deduction). You can also pro-rate based on number of rooms. If the room you rent is 1 of 5 rooms, you can deduct 20% of the electric bill in this case. Note that common use rooms like living rooms and kitchens don’t get counted as rented space. The final way you can allocate is based on people living in the condo. If you have Junior and a tenant in the house, you could reasonably allocate 50% of the water bill as a rental expense. One other thing to remember is that you’ll have to depreciate the space rented out (and pay depreciation recapture when you sell the condo). You’ll pro-rate this as well, probably using the percentage or room method.
Selling the Rental
The rental probably won’t qualify for the primary residence exclusion, so when you sell it, the total sale will be taxable. If you’ve held it for at least 1 year and a day, you’ll qualify for long-term capital gains tax rates on the normal gain. The depreciation recapture will be taxed at your marginal rate to a maximum of 25%. Both gains may be subject to the Net Investment Income Tax (NIIT). This will apply if your AGI exceeds $250,000 if you’re married or $200,000 if you’re single.
Should you Do It?
It depends. Rents around colleges are insane. Not sending that rent money to someone is tempting. Keep in mind though that a college student will be living in property you own. I know your child is a good kid and won’t be a problem. But college students living on their own are kind of like a puppy. They just do stuff….
Military Finances are Different
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