What happens to your taxes when you let a family member rent-to-own your property? The IRS has specific definitions to help, but they can get complicated.
Q: I rented our old house to my daughter and her spouse as a rent-to-own property. I told them when they paid enough money I would sign the property over to them.
Will I have to pay gift tax if I do that and is there a certain type of deed that I need to use? My health is starting to fail and I want to make sure they have the property in their names in case I die unexpectedly. I also have a piece of land that I need to deal with.
A: We’re sorry to hear that you are having health issues. And, we appreciate that you’re hoping to leave your daughter and her spouse a tidy gift rather than an unruly mess of an estate.
Now that you rented your old house to your daughter, that home may be considered a rental home on your federal income taxes. You get to treat the property as an investment property and can take some of the tax advantages available to investors, including taking depreciation on the home, deducting expenses for the upkeep and management of the home, as well as deducting real estate taxes and other expenses.
We don’t know what you paid for the home or if you’d see much profit if you were to sell it. But what we do know is on the day that you give the home to your daughter, your daughter will own the home at your cost basis.
The IRS and Your Taxes with a Rent-to-Own Home
In simple terms, the IRS defines the “cost basis” of a piece of real estate as the price you paid for it, plus all of the costs of purchase and sale (like the broker’s commission) plus the cost of any material or structural improvements (like, putting on a new roof – decorating doesn’t count). When you give someone a home, they receive it basically at the price that was paid for the home plus costs of purchase and any material or structural improvements.
So, if you paid $50,000 for the property and it is now worth $100,000, but you give your daughter the home, it would be as though she paid $50,000 for it, not $100,000. When she goes to sell it, there may be tax consequences.
When you inherit a home, you receive the home at its “stepped-up” value, which means that the property is valued at what its sales price would be on the day the person who left you the property died.
So, if you purchased your home for $50,000 and the day you die the property is valued at $100,000, your daughter’s cost basis would now be $100,000. If she turns around and sells the property the same day, she would owe no tax on the sale.
We’ve simplified the process quite a bit and there are a bunch of other details and factors that may change things for some readers. That’s why we think you should find a good estate attorney. That attorney may suggest you put the property into a living trust, so that your daughter will pay rent to you until you die, but at the time of your death, she would inherit the property (and perhaps the rest of your assets).
If the attorney sets up this living trust for you, the attorney can also put the land you own into the trust. Once the home and the land are deeded into your living trust, you can express your wishes in the trust as to how the properties should be handled. If both properties are to go to your daughter, then she can deal with the properties down the line, again, inheriting them at their current market value.
Should You Use a Gift Tax When You Rent-to-Own to a Family Member?
On the issue of gift taxes, you can give anyone you wish $15,000 per year without worrying about taxes or filing any forms with the IRS. Once you give someone more than $15,000 in any one year, you’ll end up having to file a gift tax form with your federal income tax return. Before you have to pay the IRS any money in estate taxes, the value of everything you own must be over $11,400,000 in 2019 before you’ll pay any estate taxes. (If you were married, you and your spouse would be able, with proper tax planning, to give away nearly $23 million tax-free.)
So if you die with an estate valued at less than that, you don’t have to worry about paying estate taxes or gift tax issues on a federal level. (Your estate attorney can advise you on any state tax issues your estate will face.)
The net effect is that most individuals don’t have to worry about estate taxes or gift taxes because they don’t have estates worth more than $11.4 million. And, most couples don’t have an estate valued $22.8 million. What you need to do is make sure you are able to transfer the home and the land to your loved ones without impacting your lifestyle today and without causing too much time, effort and with little cost to transfer ownership of those homes to your loved ones.
Given that you are trying to get your affairs in order quickly, please talk with an estate attorney to help address all of these questions.