Tax Considerations of Selling Primary Home to a Child

[schenbew]

DW and I have a somewhat unique situation (to us, anyhow...never did this kinda stuff before) that we would appreciate feedback on. Here's a quick summary of pertinent background info:

1. DW and I own our primary home and a SFH rental (rented out since 2017).

2. We will be renovating the SFH rental this year and move into it next year, making it our primary home. We intend to live there for many years.

3. We are exploring selling our current primary home to one of our children via seller provided financing. Looking very strongly at taking advantage of the program offered by http://nationalfamilymortgage.com to keep everything legal and easy, provide future 1098s and 1099s, registering of deeds and ownership, etc.

4. Our intent is to assist our child by offering a below market mortgage interest rate since we believe mortgage rates will stay elevated for a while, offering repayment via a 30yr seller financed mortgage. If the economic environment changes and the low mortgage rates seen last year magically reappear, we'll abandon the idea since our child will have no problem securing a mortgage on their own.

5. We are very confident our child can repay us and not worried at all about a default.

Questions:

1. If DW and I, the sellers, do not receive the entire price of the house in one transaction, how will our federal and state taxes for the house be handled? Do the taxes get spread out over several years to match the payment stream?

2. Are there alternatives to National Family Mortgage out there? We like how they consolidate the process so each party gets the appropriate tax and income related documentation and view that as a must have...not interested in having an attorney draw up documents for a sale with seller financing.

3. If and when we sell our future home, I believe we have to pay back all the depreciation we've been able to accumulate. Does that depreciation increase with inflation or does it stay constant?

4. Are there any other approaches or considerations not mentioned? We're new to the "intra-family mortgage loan" rodeo and dont want to make a colossal error.

Thanks!

 

[RobbieB]

You sold the house which may result in cap gains (less any exclusions, one time sale, that stuff)

You will need to include the interest you receive on the loan as income.

Your child deducts interest paid just as with a "outside" deal.

 

[schenbew]

RobbieB,


Thanks for the reply.



I'm good to go with what you've mentioned, but having a hard time figuring out how to do the capital gains.



I've found some references to "the installment method of reporting capital gains". No clue what that is and the IRS pubs I've looked at are clear as mud.

 

[pb4uski]

... I've found some references to "the installment method of reporting capital gains". No clue what that is and the IRS pubs I've looked at are clear as mud.

The installment method essentially pro-rates the gain in relation to the principal received. So if the gain is 32% of the purchase price then 32% of the gain is recognized in each of the year that you receive principal... thus spreading the gain over multiple tax years.

If the gain will be less than the exclusion then I think it would be easiest to not elect installment sale, recognize the entire gain in the year that your principal residence is sold. If the gain will exceed the exclusion amount, then electing installment sale might be worth looking at.

https://www.irs.gov/taxtopics/tc701

... If you sold your home under a contract that provides for all or part of the selling price to be paid in a later year, you made an installment sale. If you have an installment sale, report the sale under the installment method unless you elect out. Even if you use the installment method to defer some of the gain, the exclusion of gain under Section 121 remains available. Refer to Publication 537, Installment Sales, Form 6252, Installment Sale Income, and Topic No. 705, Installment Sales, for more information on installment sales.

 

[Z3Dreamer]

Do you have a gain of more than $500,000?

https://www.irs.gov/taxtopics/tc701

 

[schenbew]

Just checked, and our capital gain will be below the $500k exclusion. Based on pb4uski's reply, looks like the installment sale will not be necessary.

Despite that, looks like we will need to recognize the future interest component of payments we receive as income in the year we receive them.

 

[Z3Dreamer]

Do you want to charge interest?

 

[schenbew]

We will, in order to comply with the IRS Applicable Federal Rate rules (currently around 3.8% for long term loans) so our child can use the interest rate deduction and we can avoid any possible penalties.

 

[steelyman]

We will, in order to comply with the IRS Applicable Federal Rate rules (currently around 3.8% for long term loans) so our child can use the interest rate deduction and we can avoid any possible penalties.

You might want to double check the rules for allowing the interest rate deduction (for the child). Usual lenders (mortgage companies) comply with reporting rules to the IRS. The interest income for the lender should be reported in any case.

I’m not an accountant, so don’t take that as gospel.

 

[schenbew]

You might want to double check the rules for allowing the interest rate deduction (for the child). Usual lenders (mortgage companies) comply with reporting rules to the IRS. The interest income for the lender should be reported in any case.

I’m not an accountant, so don’t take that as gospel.

You're absolutely right. I wasn't aware of the rules surrounding this issue until I checked the National Family Mortgage site. They describe in detail on their site the IRS rules for complying with the law and not running afoul of IRS gift tax regulations when selling to a family member.


Their downloadable guide (page 13) explains the process and IRS rules in detail. https://www.nationalfamilymortgage.com/wp-content/uploads/2022/03/Family-Mortgage-Purchase.pdf

Avoiding these pitfalls is one of the main reasons we are considering using National Family Mortgage in this case.

 

[Dash man]

Regarding the eventual sale of your second home, if you live in it for two of the five years as your primary home you won’t owe any capital gains on the sale below the exemption amount. You will have to pay up to 25% tax on the depreciation recapture upon sale of the home. There’s no inflation adjustment involved.

 

[Z3Dreamer]

I read page 13 and, IMHO, it is written with a bias towards charging interest. AFAIK, as long as the annual imputed interest is below $16,000 per person, the IRS does not care. If you and DW jointly own the property and the imputed interest is below $32,000, you will not have any issues with IRS. If DS has spouse on the mortgage, it is $64,000. Whoever draws up the paperwork must document the specifics, but you should be OK.

Hence, my question above: "Do you want to charge interest?" What am I missing?

 

[ERD50]

This sounds like a bad idea to me.

You are essentially giving the child a 'gift' by giving them a below-market interest rate. Just let them get a mortgage on their own, keeps you out of it, and simplifies everything. If you want to help your child, just give them an annual gift (below the amount that requires any documentation or tax impact - ~ $15,000/annual, but changes with inflation).


-ERD50

 

[ERD50]

Regarding the eventual sale of your second home, if you live in it for two of the five years as your primary home you won’t owe any capital gains on the sale below the exemption amount. You will have to pay up to 25% tax on the depreciation recapture upon sale of the home. There’s no inflation adjustment involved.

I'm not so sure that is true any more. I think these rules may have been tightened up recently? OP better check this all out very carefully.

The 'catch' may be that it wasn't just a second home (like a vacation home), but a rental.

-ERD50

 

[schenbew]

I read page 13 and, IMHO, it is written with a bias towards charging interest. AFAIK, as long as the annual imputed interest is below $16,000 per person, the IRS does not care. If you and DW jointly own the property and the imputed interest is below $32,000, you will not have any issues with IRS. If DS has spouse on the mortgage, it is $64,000. Whoever draws up the paperwork must document the specifics, but you should be OK.

Hence, my question above: "Do you want to charge interest?" What am I missing?

To answer your question, no - the primary reason to do this is to assist our child. The annual interest amount at 3.8% would be well below $32,000.

So on a practical basis, if we were to charge 0% interest and skip this service, I assume we would need to recognize the gift (in the form of a 0% interest rate) on our taxes, correct?

I recognize National Family Mortgage has a clear bias to steering you towards their service by emphasizing (overly?) the "dangers" of the imputed interest issue.

 

[schenbew]

This sounds like a bad idea to me.

You are essentially giving the child a 'gift' by giving them a below-market interest rate. Just let them get a mortgage on their own, keeps you out of it, and simplifies everything. If you want to help your child, just give them an annual gift (below the amount that requires any documentation or tax impact - ~ $15,000/annual, but changes with inflation).


-ERD50

Great thought and something we've considered.



Our circumstances driving us to consider selling to our child are unique and driven by both financial and personal reasons. We're still assessing options right now, and want to understand the pros and cons of either just gifting the $ or essentially subsidizing their purchase.


The responses to my questions in this thread have been very helpful in thinking this through - thanks to all who replied.

 

[Z3Dreamer]

To answer your question, no - the primary reason to do this is to assist our child. The annual interest amount at 3.8% would be well below $32,000.

So on a practical basis, if we were to charge 0% interest and skip this service, I assume we would need to recognize the gift (in the form of a 0% interest rate) on our taxes, correct?

I recognize National Family Mortgage has a clear bias to steering you towards their service by emphasizing (overly?) the "dangers" of the imputed interest issue.

You only need to do a gift return if you have given gifts greater than $16,000. So, if your half of the imputed interest gift is less than $16,000, you do not need to file. Same with DW. There is nothing you need to do on your 1040.

Of course, I must give the "This information was provided for entertainment purposes. Please check with your accountant/lawyer before implementing any plan."

 

[schenbew]

You only need to do a gift return if you have given gifts greater than $16,000. So, if your half of the imputed interest gift is less than $16,000, you do not need to file. Same with DW. There is nothing you need to do on your 1040.

Of course, I must give the "This information was provided for entertainment purposes. Please check with your accountant/lawyer before implementing any plan."

Absolutely - we would work closely with our CPA before taking any action; the SGOTI option alone doesn't appeal to me.



As I stated initially, just gathering information and options right now. There is no deal or decision at this point.

 

[schenbew]

I'm not so sure that is true any more. I think these rules may have been tightened up recently? OP better check this all out very carefully.

The 'catch' may be that it wasn't just a second home (like a vacation home), but a rental.

-ERD50

The move isn't being driven by tax considerations; curiosity alone caused me to ask the question, not a pressing need to know. Fortunately, we'll have many years to figure out what the tax consequences are.

 

[pb4uski]

... 4. Our intent is to assist our child by offering a below market mortgage interest rate since we believe mortgage rates will stay elevated for a while, offering repayment via a 30yr seller financed mortgage. If the economic environment changes and the low mortgage rates seen last year magically reappear, we'll abandon the idea since our child will have no problem securing a mortgage on their own. ...

The easier thing might be to have your child purchase the home from you and get a mortgage. It makes your tax reporting for the sale of your principal residence more straightforward and you don't have to deal with reporing interest that they pay to you each year to the IRS.

Then as long as they have that higher rate mortgage, give then an annual gift for the difference between the market rate on their mortgage and the lower rate that you would like them to pay. So if their mortgage is $200,000 and at 7% and you wish it was at 4% then just give them a gift of $6,000 annually to make up the differece.

KISS... keep it simple Sam.

 

[schenbew]

The easier thing might be to have your child purchase the home from you and get a mortgage. It makes your tax reporting for the sale of your principal residence more straightforward and you don't have to deal with reporing interest that they pay to you each year to the IRS.

Then as long as they have that higher rate mortgage, give then an annual gift for the difference between the market rate on their mortgage and the lower rate that you would like them to pay. So if their mortgage is $200,000 and at 7% and you wish it was at 4% then just give them a gift of $6,000 annually to make up the differece.

KISS... keep it simple Sam.

This is interesting.



Based on the likely mortgage amount and current mortgage rates, the commercial mortgage would cost ~$10k/yr more. Less than the annual gift limits.

 

[Morgan22]

This is interesting.



Based on the likely mortgage amount and current mortgage rates, the commercial mortgage would cost ~$10k/yr more. Less than the annual gift limits.

Just an FYI. Gift limits are now up to $17k per person. So you and your wife could give your son $34k, you could also give another $34k to future wife without any reporting due.

Once you go over the limit for the year you would fill out form [-]706[/-] 709 [Mod Edit]. But there would be no taxes due until you go over the current $12M exemption amount. This resets to $6M I believe when the TCJA tax cuts sunset after 2025.

All limit/exemption amounts could increase every year for inflation.

 

[ivinsfan]

This is interesting.



Based on the likely mortgage amount and current mortgage rates, the commercial mortgage would cost ~$10k/yr more. Less than the annual gift limits.

Depending on your finances you might also gift to the child for extra down payment money actually lowering the interest cost and the monthly payment for a commercial loan. It does give a clean and hands off approach. Certainly less hassle.

 

[CRLLS]

Just an FYI. Gift limits are now up to $17k per person. So you and your wife could give your son $34k, you could also give another $34k to future wife without any reporting due.

Once you go over the limit for the year you would fill out form [-]706[/-] 709 [Mod Edit]. But there would be no taxes due until you go over the current $12M exemption amount. This resets to $6M I believe when the TCJA tax cuts sunset after 2025.

All limit/exemption amounts could increase every year for inflation.

^+1

 

[Morgan22]

^+1

Whoops, its form 709. I need to fix my post if I can figure out how to do that.