Adult children can obtain home ownership, acquire a more expensive home sooner, or acquire a more expensive home than they might otherwise afford, by using a shared-equity financing arrangement whereby parents or other relatives share in the purchase and cost of maintaining a house used by the children as a principal residence (Sec. 280A(d)(3)). The nonresident-owner rents his or her portion of the home to the resident-owner and obtains the normal tax benefits of renting real estate if the statutory requirements are satisfied.
Since the child does not own 100% of the home, the child is a tenant as to the portion of the home the child does not own and rents that interest from the relative at a fair market rate. The fair market rent paid for the portion of the home that the child does not own can reflect a reduction that considers that the child will take better care of the home since he or she is both a family member and an equity owner (see Bindseil, T.C. Memo. 1983-411).
Under the vacation home rules, personal use of the home by a child or other relative of the property's owner is normally attributed to the owner (Sec. 280A(d)(2)). Thus, the nonresident-owner's personal use would normally exceed the greater of 14 days or 10% of fair rental days, causing the home to be treated as a vacation home where rental deductions are limited to rental income. However, an exception to the general rule exists when the dwelling is rented to a tenant for a fair market rent and serves as the lessee's principal residence (Sec. 280A(d)(3)(A)). When the tenant owns an interest in the property, this exception to the general rule applies only if the rental qualifies as a shared-equity financing arrangement (Sec. 280A(d)(3)(B)).
A shared-equity financing arrangement is an agreement by which two or more persons acquire qualified ownership interests in a dwelling unit and a person (or persons) holding one or more of the interests is entitled to occupy the dwelling as his or her principal residence and is required to pay rent to the other person(s) owning qualified ownership interests (Sec. 280A(d)(3)(C)). A qualified ownership interest is defined as an undivided interest for more than 50 years in the entire dwelling unit and any appurtenant land being acquired in the transaction to which the shared-equity agreement relates (Sec. 280A(d)(3)(D)). Actual ownership of at least 50 years is not required; i.e., the property may be disposed of before 50 years have passed and still qualify.
Example: M and L have agreed to help their son, B, purchase his first home. The total purchase price is $100,000, consisting of a $20,000 down payment and a mortgage of $80,000. M and L pay half of the down payment and make half of the mortgage payment pursuant to a shared-equity financing agreement with B. B pays them a fair rental for using 50% of the property, determined when the agreement is entered into.
Under this arrangement, B treats the property as his personal residence for tax, deducting his 50% share of the mortgage interest and property taxes. Because his use is not attributed to his parents, M and L, they treat the property as a rental. They must report the rent they receive from B but can deduct their 50% of the mortgage interest and taxes, the maintenance expenses they pay, and depreciation based on 50% of the property's depreciable basis. If the property generates a tax loss, it is subject to the passive loss rules (i.e., a loss can be generated; the expenses are not limited to the rental income under the vacation home rules).
Note: For the resident-owner, the income tax benefits of home ownership may not be as significant as anticipated because the resident-owner's deductions for mortgage interest and real estate taxes are based on his or her ownership percentage. But the shared-equity arrangement reduces the resident-owner's cash outlay, which may be more important than tax savings.
Caution: If it is anticipated that the resident-owner (the child) will ultimately purchase the equity of the nonresident-owner (typically a parent) and the rental will generate losses suspended under the passive loss rules, special care must be taken when the lease terms are agreed to, because suspended passive losses normally allowed at disposition are not allowed when the interest is sold to a related party (Sec. 469(g)(1)(B)). Passive losses that would otherwise be suspended may be minimized by making a larger down payment that decreases mortgage interest expense or by charging a rent at the higher end of the reasonable range for the value of the interest being rented to the resident-owner.
Planning tip: One drawback to shared-equity arrangements is that the nonresident-owners will not qualify for the Sec. 121 gain exclusion upon the sale of the residence. The result will be a taxable gain for the portion of the gain related to the deemed rental. The gain may also be subject to the 3.8% net investment income tax. Clients should consider guaranteeing or co-signing the mortgage, instead of outright joint ownership, if excluding potential future gain is a major consideration. This should allow the resident-owner to exclude all the gain (up to $250,000 for single taxpayers or $500,000 for married taxpayers filing jointly). But this may be impractical if the resident-owner needs cash for a down payment and/or mortgage payments.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 19th edition (March 2018), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.