Help....renting a parent's house

[PandaBear]

My mom has decided to move to a retirement community. She currently owns a home in a HCOL area. She will be moving to a different state (where she was born and raised and still has family and friends) with significantly lower cost of living.

My understanding is that if she were to sell her house now, she would use the cost basis from when my dad died (2016), have a 250K exemption and pay taxes on the rest. So, for example, the house was purchased for 25K, was appraised at about 1.5 million in 2016 and is currently valued at 2 million. She'd pay taxes on 250K (I think).

She would like to rent it. I think we'd get about 5k per month. My question is: what are the tax ramifications if she rents it and decides to sell it later? Does she lose the step up she got when my dad died?

The house is in her trust. When she is gone, are there any ramifications for her heirs by her having rented it rather than living in it?

I also have an appointment with a tax guy to ask these questions, but I thought if I had some understanding before the appointment begins, Id be better off!

 

[Sunset]

I believe if she rents it for 5 years, she will lose the $250K exemption, if she then sold it.
As a really rough approximation, I'd guess that would cost an extra $60K in taxes at the time of sale.

Besides the money aspect, who is going to manage the rental ?
Renting at this time, when someone can move in and stop paying rent and not be evicted is a risk.

ETA: If OP is saying they would rent it out for 5K per month, that is extremely under priced for a 2M home.

 

[Philliefan33]

Did your mom jointly own the house with your father? If so, I believe she only gets the stepped-up basis on your father’s half of the house at the time of his death. That subtracts roughly $750,000 from the basis of the house in your calculation.

If she rents the house, she should take the depreciation for each year it is rented. Whether she takes the depreciation or not, the allowed depreciation will be subtracted from the cost basis at the time she sells. (It’s a little more complicated than that; she will end up paying income tax on the depreciation at her regular rate, not LT capital gains rate, when she sells the house).

If your mother doesn’t live in the house for at least two of the five years previous to selling the house, she loses the $250K exemption.

Bottom line, there will be a big tax bill when she sells the house. That bill will be even bigger if she rents it. It will will very big if she sells after not living there for five years.

 

[phil1ben]

Also ask your tax guy what federal tax rate will apply to the rental income since the house is owned by a trust. Trusts have vastly different tax brackets than individuals. Just pulled the below 2020 trust federal tax rates from a site online:

$0 to $2,600 in income: 10% of taxable income
$2,601 to $9,450 in income: $260 plus 24% of the amount over $2,600
$9,450 to $12,950 in income: $1,904 plus 35% of the amount over $9,450
Over $12,950 in income: $3,129 plus 37% of the amount over $12,950

It appears that much of her rental income will be taxed at the 37% federal tax rate not to mention applicable state income tax rates.

 

[cathy63]

... My understanding is that if she were to sell her house now, she would use the cost basis from when my dad died (2016), have a 250K exemption and pay taxes on the rest. So, for example, the house was purchased for 25K, was appraised at about 1.5 million in 2016 and is currently valued at 2 million. She'd pay taxes on 250K (I think)....

Did your mom jointly own the house with your father? If so, I believe she only gets the stepped-up basis on your father’s half of the house at the time of his death. That subtracts roughly $750,000 from the basis of the house in your calculation...

What state is the house located in? If it's in a community property state such as CA or TX, then your mother got a step-up in basis on the full value of the house. Her current basis would be $1.5M + cost of permanent improvements made since your father died. If it's not in a community property state, then I agree with Philliefan33 that she only got a step-up on your father's half of the house.

If she sold the house now, she would pay tax on SalePrice - SaleCost - CurrentBasis - $250K. The realtor sales commission on a $2M house will eat up a significant portion of the taxable $250K.

What kind of a trust(s) currently own the house? Is the house 100% owned by your mother's revocable living trust? If so, then any rental income is reported on her return and taxed at her own personal rate. If it's half owned by an irrevocable trust that was established at your father's death, then it's more complicated and you need a tax expert to help you.

 

[PandaBear]

I believe if she rents it for 5 years, she will lose the $250K exemption, if she then sold it.
As a really rough approximation, I'd guess that would cost an extra $60K in taxes at the time of sale.

Besides the money aspect, who is going to manage the rental ?
Renting at this time, when someone can move in and stop paying rent and not be evicted is a risk.

ETA: If OP is saying they would rent it out for 5K per month, that is extremely under priced for a 2M home.

Thanks for your input. The 5k is an estimate. It could possibly rent for more. We won’t rent it right away. My mom plans to move in May and my son will live there temporarily, just so someone is in the house. He won’t pay rent.

We would anticipate not renting it until at least 2022.

We are trying to figure out the tax ramifications of renting it and then selling it, as well as renting it out long term until my moms death. Another option is having a different son move in, so it’s not empty and not pay rent over the next year, just until my mom decides what she wants to do.

 

[PandaBear]

Did your mom jointly own the house with your father? If so, I believe she only gets the stepped-up basis on your father’s half of the house at the time of his death. That subtracts roughly $750,000 from the basis of the house in your calculation.

If she rents the house, she should take the depreciation for each year it is rented. Whether she takes the depreciation or not, the allowed depreciation will be subtracted from the cost basis at the time she sells. (It’s a little more complicated than that; she will end up paying income tax on the depreciation at her regular rate, not LT capital gains rate, when she sells the house).

If your mother doesn’t live in the house for at least two of the five years previous to selling the house, she loses the $250K exemption.

Bottom line, there will be a big tax bill when she sells the house. That bill will be even bigger if she rents it. It will will very big if she sells after not living there for five years.

Good to know about depreciation. I didn’t realize that. We are in CA, so I believe she gets the full amount from the value when my dad died.

I appreciate your input

 

[PandaBear]

What state is the house located in? If it's in a community property state such as CA or TX, then your mother got a step-up in basis on the full value of the house. Her current basis would be $1.5M + cost of permanent improvements made since your father died. If it's not in a community property state, then I agree with Philliefan33 that she only got a step-up on your father's half of the house.



If she sold the house now, she would pay tax on SalePrice - SaleCost - CurrentBasis - $250K. The realtor sales commission on a $2M house will eat up a significant portion of the taxable $250K.



What kind of a trust(s) currently own the house? Is the house 100% owned by your mother's revocable living trust? If so, then any rental income is reported on her return and taxed at her own personal rate. If it's half owned by an irrevocable trust that was established at your father's death, then it's more complicated and you need a tax expert to help you.

We are n CA. Because the trust was redone after my dads death I don’t know the answer for sure. I appreciate the info.....I will look more into this.

 

[PandaBear]

Thank you to everyone who commented. I learned more about what I need to learn before I meet with the tax person. That’s exactly what I was hoping to get.....what more should I investigate.

Potentially, for the cost, energy and effort, it may be better to let one of the grandkids live there rent free (just paying the utilities) for a year while my mom decides to rent it out forever or selling.

The last big question I have is.......how does renting the house out now impact the inheritance? Meaning, assuming tax laws don’t change, if my mom lived there until her death, the kids inheriting would get the step up basis of the house, so selling it would mean basically no tax bill.

If she rents it until her death and its sold after her death by the heirs, do they still get the stepped up tax base? Or are there ramifications?

Thanks

 

[RE2Boys]

Since it was mentioned that your MoM will be moving to another state, keep in mind that if you rent the house in a state different from the one she is actually a resident of, she may be required to file two separate state income tax returns.

 

[Koolau]

We are n CA. Because the trust was redone after my dads death I don’t know the answer for sure. I appreciate the info.....I will look more into this.

It's complicated as indicated in responses above. Spend some money to work with a good CPA/tax person to figure out what is best to do. Renting - especially remotely - may be more trouble than it's worth. We went through this several years ago when we moved into a property we had rented out for several years. By living there for 2 years, we got our $500K (for 2 of us) exemption BUT had to pay tax on all of our depreciation - which we had taken.

Be certain you are okay with renting out a property. You might even want to consult an attorney about current law - keep in mind laws can be changed upon the whim of a legislature. Renting has many potential pitfalls as the recent Covid crisis has pointed out. You may find out that "owning" something is not the same as "controlling" it. Many states lean toward renters' rights at the expense of owners' rights. Just a word to the wise - check it out FIRST since YMMV.

 

[cathy63]

Thank you to everyone who commented. I learned more about what I need to learn before I meet with the tax person. That’s exactly what I was hoping to get.....what more should I investigate.

Potentially, for the cost, energy and effort, it may be better to let one of the grandkids live there rent free (just paying the utilities) for a year while my mom decides to rent it out forever or selling.

The last big question I have is.......how does renting the house out now impact the inheritance? Meaning, assuming tax laws don’t change, if my mom lived there until her death, the kids inheriting would get the step up basis of the house, so selling it would mean basically no tax bill.

If she rents it until her death and its sold after her death by the heirs, do they still get the stepped up tax base? Or are there ramifications?

Thanks

There are no tax consequences for the heirs. Real estate gets a step-up in basis regardless of whether it's rented or not.

 

[PandaBear]

There are no tax consequences for the heirs. Real estate gets a step-up in basis regardless of whether it's rented or not.

Thank you!

 

[mnopqr]

You may also want to check the effect of California Prop. 19. This is a recent change to Prop. 13 and has ramifications for CA property taxes. One of which applies to children inheriting property from their parents.

 

[Sunset]

OP - the other issue is that housing is extremely HOT right now. The property would sell quickly and probably for more than expected.

The costs to carry the house for insurance, water, electricity, repairs, maintenance, etc must run $20K (as a guess) per year.

 

[NgineER]

I am a proponent of rental properties, but the rental income does not reflect the value of the property. At this time tech is very hot and therefore also at least the Bay Area.

Also include the risk of someone suing you while it is a rental and you might lose the property.

If you don’t have an interest in the property, take the bird in hand and pay taxes on it. Prices might go up for another decade, but you could also have a SPAC implosion or China issue and prices might drop.

Who knows...

 

[ncbill]

Seems like it's hard to rent SFR properties in HCOL areas for a decent return.

Financial Samurai came to the same conclusion with a SFR in San Francisco and so sold it.

 

[Koolau]

Seems like it's hard to rent SFR properties in HCOL areas for a decent return.

Financial Samurai came to the same conclusion with a SFR in San Francisco and so sold it.

True. In many average COL areas, the old 1%/month rule seems to work most of the time. Here in Paradise, you would be hard pressed to get 1/2% of current value/month as rent (probably closer to 1/3% per month.) I think the way most folks think of renting out HCOL areas is that 1) you have locked in the purchase price and can rent out the property until you eventually move in. This is what we did. Or 2) renting to recoup some of your costs (for instance, mortgage interest costs) while the property zooms up in price for an eventual "flip." (Profit comes from increased property value rather than from rent.) I'm sure there are other ways to justify renting at less that 1%/month.

Until Covid hit, local law was reasonably favorable to landlords (not unfair to renters, but, for instance, no rent control and reasonable eviction process.) I wouldn't even consider renting out a property in todays Covid environment - and I would never rent out a property in any state which had any type of rent control. Very much a YMMV situation.

 

[PandaBear]

You may also want to check the effect of California Prop. 19. This is a recent change to Prop. 13 and has ramifications for CA property taxes. One of which applies to children inheriting property from their parents.

Thank you. Luckily the changes won’t impact us.

 

[PandaBear]

OP - the other issue is that housing is extremely HOT right now. The property would sell quickly and probably for more than expected.

The costs to carry the house for insurance, water, electricity, repairs, maintenance, etc must run $20K (as a guess) per year.

This is one of those situations where the most practical solution isn’t an option, at least at the moment. It is what it is.

 

[PandaBear]

I am a proponent of rental properties, but the rental income does not reflect the value of the property. At this time tech is very hot and therefore also at least the Bay Area.

Also include the risk of someone suing you while it is a rental and you might lose the property.

If you don’t have an interest in the property, take the bird in hand and pay taxes on it. Prices might go up for another decade, but you could also have a SPAC implosion or China issue and prices might drop.

Who knows...

Unfortunately I don’t get to decide what happens to the property. It’s not mine. I can give some input but my mom and brother currently don’t want to sell it. That’s why I’m trying to have a good understanding of both so I can prepare a pro and con list for both options.

 

[wolf]

You may also want to check the effect of California Prop. 19. This is a recent change to Prop. 13 and has ramifications for CA property taxes. One of which applies to children inheriting property from their parents.

Critical. Be sure your Advisor understands Prop 19. California, took effect,
I think in Feb. 2021.

1. Your Mom's property tax, is based on her cost basis. What she paid for it.
Look at property tax bill. Very low most likely. ie. $3000 range.

2. Assume, converted to Rental. Mom passes. The Rental is reassessed
to market value. And the property tax is re assessed.

ie. Rental is worth $ 1,500,000. New Property tax will be around $ 19,500.

3. If house remains, mom's personal residence. Prop 19, has exemption.
Mom's child must live in the house.
Residence is reassessed, but you are granted $ 1 million exemption
when figuring out the new property tax. (exemption for determining basis, not the property tax)

4. However, if your Mom, is living in a different state. Even if one of her
children live in the house, you will not get the $ 1 million exemption.
Mom must be living in the house. (her personal residence).

5. Proof of mom living in house, she must claim the home owner's
exemption, which shows up on the property tax bill.

6. So whether rented or not. In your situation, your new property tax, can be $19,500.
Again, hypothetical. I just "guessed" at the home values.

Sorry for the long rant. I live in CA, so familiar, with high cost of living and home prices.

 

[PandaBear]

Critical. Be sure your Advisor understands Prop 19. California, took effect,
I think in Feb. 2021.

1. Your Mom's property tax, is based on her cost basis. What she paid for it.
Look at property tax bill. Very low most likely. ie. $3000 range.

2. Assume, converted to Rental. Mom passes. The Rental is reassessed
to market value. And the property tax is re assessed.

ie. Rental is worth $ 1,500,000. New Property tax will be around $ 19,500.

3. If house remains, mom's personal residence. Prop 19, has exemption.
Mom's child must live in the house.
Residence is reassessed, but you are granted $ 1 million exemption
when figuring out the new property tax. (exemption for determining basis, not the property tax)

4. However, if your Mom, is living in a different state. Even if one of her
children live in the house, you will not get the $ 1 million exemption.
Mom must be living in the house. (her personal residence).

5. Proof of mom living in house, she must claim the home owner's
exemption, which shows up on the property tax bill.

6. So whether rented or not. In your situation, your new property tax, can be $19,500.
Again, hypothetical. I just "guessed" at the home values.

Sorry for the long rant. I live in CA, so familiar, with high cost of living and home prices.

Thank you for sharing. I am thinking your information is assuming we plan to keep he house after my mom passes?

In our situation, the three options are:
#1
1. Mom relocates from CA to midwest. She moves into retirement community (rental, no purchase).
2. Home is rented. Mom uses income to pay for retirement community.
3. Mom passes. House is sold by heirs.

OR #2
1. Mom relocates from CA to midwest. She moves into retirement community (rental, no purchase).
2. Home is temporarily occupied by family members (over about 6 months) to help maintain it and then sold.

OR #3
1. Mom relocates from CA to midwest. She moves into retirement community (rental, no purchase).
2. Moms home is rented.
3. Mom decides she wants to stay where she moved and house is sold.

My mom does not want to choose the #2 option. She wants to do #1, although #3 is possibly an option.

So my concern is not the taxes after she passes. My concerns are primarily
1. That the heirs receive the step up basis after mom passes if the house is rented,
2. That we can retain the 250K exemption if its rented, as long as its within the living 2 years of 5.
3. My third is whether ir not my mom gets the step up basis from ghe time of my dads death if she should choose to sell and not rent it out. She and my dad had an old A/B trust, which was never updated. My mom had a new trust created after his death.

 

[beyou]

Unfortunately I don’t get to decide what happens to the property. It’s not mine. I can give some input but my mom and brother currently don’t want to sell it. That’s why I’m trying to have a good understanding of both so I can prepare a pro and con list for both options.

WHY does she not want to sell ?
And why is it your brother’s decision but not yours ?

This seems to me similar to the aversion to sell a stock.
You need to ask yourself, “would I buy this house TODAY as an investment and rent it out ?”. If the answer is no, why hold what you would not buy ? Sell and buy something that is a good investment for her now, relative to her current needs (to fund her retirement community costs).

I personally would not want to be a landlord for property located far away.
Having one property gives you concentration risk in your “portfolio”.
Would your brother manage the rental locally ? If not why is his opinion weighing in here ?

 

[NgineER]

Thank you for sharing. I am thinking your information is assuming we plan to keep he house after my mom passes?


1. That the heirs receive the step up basis after mom passes if the house is rented,

Yes-you do get a step up in basis on a rental property as well.

This seems to me similar to the aversion to sell a stock.
You need to ask yourself, “would I buy this house TODAY as an investment and rent it out ?”. If the answer is no, why hold what you would not buy ?

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