I have two kids in their mid 20s that both rent houses from me. In both cases, I paid cash for the house using money I was rebalancing out of bond funds over the last couple years. I didn't like stocks at the time and real estate in this area was still affordable. My only expenses are property tax and insurance. The kids pay all utilities, maintenance and upkeep. I get about 6-7% pre-tax return on invested capital, and the kids get a house for about the same rent as they were previously paying for a run-down apartment.
Both kids have good income, but don't have sufficient credit history and lack the after-tax savings for a downpayment. So this was a nice way to get them into a house sooner, while providing me with a reliable income-producing asset with a lot more upside potential than bonds. Win-win.
For tax purposes, we account for this as passive business activity on Schedule E, where we take depreciation expense along with property tax and insurance. The depreciation drives a lower tax rate on this income stream compared to bond interest as well. The rent is a little below market, but high enough that, combined with the maintenance arrangement, should not cause any problems with the IRS.
Depending on what happens in the future, either house would also be a nice "downsize" option for us. I must admit it's a little weird entering into a business arrangement with your kids, but the mutual benefits are significant, so we all got over the weirdness pretty quickly.
Retired at 52 in July 2013. On to better things...
AA: 45% stock, 35% bonds, 15% real estate, 5% cash