Clarification of Answer by
keystroke-ga
on
28 Jul 2006 05:01 PDT
mk2006,
You bring up some interesting points.
(And before I begin, I must emphasise that I cannot provide full legal
advice as Google Answers is not allowed to do so.)
Here is what more I could find from the IRS on the subject.
"You must be legally liable for the loan. You cannot deduct payments
you make for someone else if you are not legally liable to make them.
Both you and the lender must intend that the loan be repaid. In
addition, there must be a true debtor-creditor relationship between
you and the lender."
http://www.irs.gov/publications/p936/ar02.html#d0e182
Technically, you are making interim payments for someone else, but you
are not disqualified under this clause. You ARE legally liable for the
loan-- it is in your name and you must pay it back to the lender. In
this example, your brother and his girlfriend, even though technically
they may be paying the loan back for you, cannot deduct the interest,
but you still could withstanding this clause.
"For you to take a home mortgage interest deduction, your debt must be
secured by a qualified home. This means your main home or your second
home. A home includes a house, condominium, cooperative, mobile home,
house trailer, boat, or similar property that has sleeping, cooking,
and toilet facilities."
Check. Your debt is secured by a qualified home.
"Main home. You can have only one main home at any one time. This is
the home where you ordinarily live most of the time."
Since you won't be living there most of the time, the house won't
count as a main home.
"Second home. A second home is a home that you choose to treat as
your second home."
Now, since you have your apartment and live in it primarily, your
house in Tennessee would be your second home. The tricky part is
whether it would be considered rent or not!
"Second home not rented out. If you have a second home that you do
not hold out for rent or resale to others at any time during the year,
you can treat it as a qualified home. You do not have to use the home
during the year."
Now, in my opinion (and I am not a tax lawyer) you will not be
"holding" the place out for rent or resale to others at any time-- no
newspaper ads or Craigslist. The definition of "rent" is: "Payment,
usually of an amount fixed by contract, made by a tenant at specified
intervals in return for the right to occupy or use the property of
another."
http://www.answers.com/topic/economic-rent
Now, under this definition it is possible that the monthly payments
that your brother and his girlfriend send to you could be construed as
rent. Donors are allowed to give someone else up to $11,000 per year
in gifts before incurring the gift tax, and since there are two of
them, their checks would easily be kept under the limit. However, this
is a violation of the gift tax rule. "A 'gift' you receive in exchange
for services or some other consideration isn't a gift."
http://www.fairmark.com/begin/gifts.htm
While technically the payments they send you might appear to be rent,
it is entirely possible for someone to charge someone "rent" and not
be considered a landlord. Many parents whose children move back into
their childhood rooms charge their kids rent, but the parents don't
have to report that income to the IRS.
"Rent that you charge your children typically is not reported as
income on your tax return, and related expenses (such as paint for
their room, utilities, and food) are not deductible as rental
expenses."
http://hffo.cuna.org/story.html?doc_id=629&sub_id=12433
This is a possibility, but I researched what might happen if the
payments are considered rent and you are acting as landlord. Here is a
very interesting article:
http://www.cmicpa.com/articles/8
According to this article, it would be BETTER for you to charge your
brother and his girlfriend rent than not to charge them:
"When you rent a home to a family member, you run into several possible tax traps.
The best results come if you rent to a related party (family member)
with the family member paying rent to you at fair market value. In
this case, you get to deduct all mortgage interest, real estate taxes,
property insurance, homeowner association dues, and any other ordinary
and necessary expenses to maintain the property, plus you may
depreciate the cost of the building. After all these deductions, you
may well get to deduct a net loss, which reduces other taxable income.
When you sell the property, you have capital gain (there is no gain
exclusion assuming you have not lived in the property yourself and do
not qualify for the gain exclusion).
The worst case scenario is this: you rent to the family member at less
than fair rental value, or at no rent at all. In this case, you are
subject to the vacation home rules, and you may only deduct expenses
up to the amount of rent you have received, with the rest, being
nondeductible personal expenses. The mortgage interest becomes
investment interest, and the deduction for investment interest is
limited to investment income (interest÷nds&capital gains). If
you sell the property at a loss, the loss is nondeductible (personal
loss). Of course, if you sell at a gain, that is taxable (the IRS has
this game rigged).
Some people buy homes for family members to live in, and fail to
become aware of the traps (particularly charging small or no rent).
Also, some people will suppose they will get the residence gain
exclusion on these types of properties, and that doesn't work either,
because it is the owner who has the requirement to own, use, and live
in the property for 2 of 5 years. So, you need to think short-term and
long term as well."
Now, this situation appears to be superior to that of just deducting
the mortgage interest as a personal homeowner with a non-rented second
home. You can deduct all fees related to the upkeep, such as
insurance. However, you would have capital gain when you "sold" the
house to your brother, depending on how that situation is applied.
But there are many ways to reduce capital gain, such as adding to the
base home cost by making home improvements, etc. The exceptions for
paying capital gains taxes are:
1. You owned your home for at least two years.
1. You lived in it as your primary residence for two out of the last five years.
Since it won't be your primary residence, it seems that you would owe
capital gains tax no matter what, so this is not explicity caused by
the rental situation.
Generally, when you rent to tenants, the Internal Revenue Service does
allow you to deduct rental expenses like mortgage interest, taxes,
casualty losses, maintenance, insurance and depreciation. This reduces
the amount of rental income that's taxed. But if you use your dwelling
as a home and rent it for fewer than 15 days, you don't report any of
the rental income, nor do you deduct any rental expenses.
Here is some additional info on renting out your home from Publication
527 from the IRS:
-http://www.irs.gov/publications/p527/ar02.html#d0e222
--You must report rent as income.
"Rental income is any payment you receive for the use or occupation of property."
Items that you can deduct include:
" *
Advertising.
*
Cleaning and maintenance.
*
Utilities.
*
Insurance.
*
Taxes.
*
Interest.
*
Points.
*
Commissions.
*
Tax return preparation fees.
*
Travel expenses.
*
Rental payments.
*
Local transportation expenses."
"Interest expense. You can deduct mortgage interest you pay on your
rental property. Chapter 5 of Publication 535 explains mortgage
interest in detail.
Expenses paid to obtain a mortgage. Certain expenses you pay to
obtain a mortgage on your rental property cannot be deducted as
interest. These expenses, which include mortgage commissions, abstract
fees, and recording fees, are capital expenses. However, you can
amortize them over the life of the mortgage.
Points. The term ?points? is often used to describe some of the
charges paid by a borrower to take out a loan or a mortgage. These
charges are also called loan origination fees, maximum loan charges,
or premium charges. If any of these charges (points) are solely for
the use of money, they are interest.
Loan or mortgage ends. If your loan or mortgage ends, you may be
able to deduct any remaining points (OID) in the tax year in which the
loan or mortgage ends. A loan or mortgage may end due to a
refinancing, prepayment, foreclosure, or similar event. However, if
the refinancing is with the same lender, the remaining points (OID)
generally are not deductible in the year in which the refinancing
occurs, but may be deductible over the term of the new mortgage or
loan.
Travel expenses. You can deduct the ordinary and necessary expenses
of traveling away from home if the primary purpose of the trip was to
collect rental income or to manage, conserve, or maintain your rental
property. You must properly allocate your expenses between rental and
nonrental activities. You cannot deduct the cost of traveling away
from home if the primary purpose of the trip was the improvement of
your property. You recover the cost of improvements by taking
depreciation. For information on travel expenses, see chapter 1 of
Publication 463."
If I were you, I would first contact a trusted tax adviser and consult
on what the property could be classified as. (My guess is that it
might best come under the "rental" banner, but I am no tax
professional.) If it can qualify as both, I would go through and
debate the benefits of each. It seems that if you qualify the home as
a rental, you could even deduct travel expenses to Tennessee to check
on the property, and of course you could deduct the interest. You
would have to declare the "rent" as income, however, which might
cancel out the benefits of the other clauses. It is also a possibility
to hold the property for personal use for part of the year, and rental
use for the other part.
If you don't want your brother's payments to be counted as rent, you
could prove that they are not rent by the very fact that his name is
in the title. He partially "owns" the house, and so he can't very
well pay rent to live there. These payments are what muck up the
situation. The IRS definiton of a "second home" is this:
"Second home not rented out. If you have a second home that you do
not hold out for rent or resale to others at any time during the year,
you can treat it as a qualified home. You do not have to use the home
during the year."
I'm afraid the IRS doesn't list on their website specific provisions
for everything, including your situation. Those provisions probably do
exist, though, and so a professional would be able to help you more
than I. From what I can see, you should be able to treat the payments
either way you want, as rent or as repayment of a loan which you took
for your brother. Your house does fall under the second home
provision, but that depends on whether the payments are counted as
rent.
Now, while I could not find any specific IRS provisions, I did find a
page that matches your situation somewhat closely. The advice to that
person (whose brother was actually on the mortgage, too) was to use
the place as a rental and take the rental benefits allowed. Here's
the page:
http://www.realestatejournal.com/columnists/ownersmanual/20051011-hodges.html
"Question: My brother and I are thinking about purchasing a house in
Martha's Vineyard, Mass. He would use it as a primary residence. I
rent an apartment in New York. The house would be the only home I own,
but I only would be there on weekends in the summer. We are
considering setting up an LLC in our names. We both would take out a
mortgage and would own the house 50/50. Would my mortgage be fully tax
deductible as a primary residence?"
"Regardless of whether you decide to take the tenancy-in-common route,
Mr. Hall notes that your intended uses of the property could subject
you to taxes on what the IRS calls "imputed rental income." The short
definition: The IRS may view your use of the property as one in which
a half-owner (your brother) is paying the other half-owner (you)
nothing for his use of your half of the property. According to IRS
logic, theoretically you are "gifting" him use of your property, and
since he is not your dependent, you must report the fair rental market
value as income and pay tax on it. This is a peculiar form of income
tax, but it may apply in your case. If the IRS does view your half as
a rental, you could take additional deductions on your income-tax
filing, including expenses for home repairs, maintenance and
depreciation, Mr. Hall says.
If your brother plans on using the whole property, you are better off
treating your half as a rental and charging your brother rent, Mr.
Hall says. This way, you are eligible for a business loss deduction if
the property loses value or capital gains tax treatment if it goes up
when you sell. Either way, you are covered.
Jake Engle, a certified financial planner in Seattle and principal of
Financial Planning & Education LLC, says he agrees that a
tenancy-in-common or a formal rental arrangement could benefit you. He
urges you and your brother to devise a full "partnership agreement"
about use of the jointly run property, complete with "exit strategies"
and rules. Any "couple," whether a set of friends, siblings, or
romantic partners who buy property together and are not married, need
to think about the future."
On the basis of all this evidence, I would venture to say that it
seems that you would be best served treating the property as a rental.
You would have to pay income tax on the income, but you would also get
the deductions for home improvements, insurance, mortgage interest,
upkeep, depreciation, and you could benefit when you sell on the
capital gains.
In sum, you will have to contact either the IRS or a lawyer to get
full confirmation of what will be allowed tax-wise on your house. Even
in the above situation, when the CPAs are tax experts themselves, they
could not give 100 percent advice to the questioner because situations
are always different and there are many, many loopholes. The IRS
recommends to contact them thusly: " If you have a tax question, visit
www.irs.gov or call 1-800-829-1040. We cannot answer tax questions at
either of the addresses listed above." I have spent a few hours
looking into these questions but I am by no means a professional! I
hope I've been of some help, however.
I hope I've helped you a bit though!
Now, let's look into transferring the title.
According to the IRS rules, capital gains taxes exemptions apply up to
$250,000 when selling your primary home (that you have lived in for 2
of the last 5 years). Since it does NOT qualify as your main home, it
seems that you would have capital gains taxes on the sale to your
brother, if the price he pays you is more than what you paid for it.
That is the "capital gain." In my estimate, three scenarios could
arise:
1. You transfer the house to your brother without selling it to him.
You would be considered as giving him the house as a "gift" and might
be eligible for gift taxes.
2. You sell the house to him for what you paid for it. If the house
has appreciated in value-- for example, if the house goes up in value
to $300,000 in that time period, you would be considered as giving him
an $80,000 gift. You could give your brother up to $11,000 tax-free
annually in gifts, and I presume you could give his girlfriend $11,000
tax-free too.
3. You sell the house to him for its market value. This would preclude
the gift tax, but this is the situation in which capital gains would
come into play. If you paid $220,000 for the house and then sold it to
your brother for $230,000, you would have capital gain. If you sell it
for less than what you paid, you can't deduct the capital loss. You
would owe the capital gains tax, not your brother or his girlfriend,
but as you are conducting the entire deal as a huge favor to them if
they are sensible they will pay the capital gains tax for you.
The best option among these might be to sell it to them for what you
paid, and any appreciation be considered a gift.
Here is a page that includes all the forms that come into play when a
property is transferred in Tennessee:
http://www.knoxville-tn.com/pforms.html
Ways that you can transfer the title:
a grant deed
http://dictionary.law.com/default2.asp?selected=832&bold=%7C%7C%7C%7C
Sources:
IRS Publication 936
http://www.irs.gov/pub/irs-pdf/p936.pdf
Search terms:
irs.gov mortgage interest deduction
rent second home mortgage interest
renting to co owner
"imputed rental income"
capital gains taxes irs.gov
It's still a bit too early in the morning for me, so excuse me if I
have not been clear on some issues and you still need further
clarification. Let me know.
--keystroke-ga
