With real estate prices recovering in many markets, it might make sense to buy a condo where your child can live during college. He or she can live there while attending school, and you can avoid “throwing away” money on dorm costs or rent for an apartment. If you buy a place that has extra space, you also can rent it to your child’s friend(s) to offset some of the ownership costs.
Additionally, you may be able to sell the condo for a gain after the four or five (or maybe even six) years that it takes for your son or daughter to graduate. A gain may be even more likely if you have more than one child — and you can persuade a younger child to attend the same college as an older sibling. Here are some tax issues to consider before you buy a condo near campus.
Rules about Deducting College Condo Ownership Costs
The federal income tax rules generally prevent you from deducting losses from owning and renting out a residence to a family member. But an exception applies when you rent at market rates to the family member who uses the property as his or her principal home. This loophole is open to you if you buy a condo and rent it out to your college kid (and any roommates) at market rates.
As long as you charge market rent, you can — subject to the passive activity loss (PAL) rules explained later — deduct the mortgage interest and write off all the other operating expenses, including utilities, insurance, association fees, security monitoring, cleaning, maintenance and repairs. As a bonus, you can depreciate the cost of the structure (but not the land) over 27.5 years, even if its market value is increasing.
Where will your cash-strapped college student get the money to pay you market rent for the condo? The same place he or she would get the cash to pay for a dorm room or apartment rent. You can gift your child up to $14,000 annually without any adverse federal tax consequences. If you’re married, you and your spouse, combined, can give up to $28,000. Your child can then use that money to write monthly rent checks back to you.
For recordkeeping purposes, your child should send checks that say “rent” on the memo line. It’s also helpful for you to open a separate checking account to handle rental income and expenses. Taking these steps will minimize problems with the IRS if you get audited.
Key point: Even if you don’t charge your child market rent for the condo, you can still deduct the property taxes. Designate the condo as your second home, and then you can also deduct the interest on up to $1.1 million of combined mortgage debt on your main home and the condo as an itemized deduction on your personal tax return (subject to the phaseout rule for high-income folks that normally applies to these deductions).
Watch Out for PAL Rules
The condo is likely to generate tax losses after you consider depreciation deductions. If so, the PAL rules generally apply. The fundamental concept is simple: You can deduct PALs only to the extent you have passive income from other sources, such as positive taxable income from other rental properties or gains from selling them.
A special exception allows you to deduct up to $25,000 of annual PALs from rental real estate provided:
- Your adjusted gross income before the real estate loss is less than $100,000, and
- You “actively participate” in the rental activity.
Active participation means you’re making management decisions, such as approving tenants, signing leases and authorizing repairs.
If you qualify for this exception, you won’t need any passive income to claim a deductible rental loss of up to $25,000 annually. However, if your adjusted gross income (AGI) is between $100,000 and $150,000, the special exception gets proportionately phased out. If your AGI exceeds $150,000 and you have no passive income, you can’t currently deduct any passive rental real estate losses. Fortunately, any unused losses will be carried forward to future tax years, and you can deduct them when you sell the condo.
Expect More Tax Benefits When You Sell
When you sell a rental property that you’ve owned for more than a year, the profit — the difference between sales proceeds and the tax basis of the property after subtracting depreciation — is a long-term capital gain.
For most folks, the maximum federal tax rate on long-term gains is 15%. But if you are in the top federal bracket, the maximum rate is 20%. Higher-income taxpayers may also owe the 3.8% net investment income tax on rental property gains. Also be aware that, if you’re in the 25% regular income tax bracket or above, part of the gain — the amount equal to your cumulative depreciation write-offs — is taxed at a maximum federal rate of 25%.
Finally, remember those carryover passive losses that we talked about earlier? You get to use them to shelter all or part of the gain from selling the place.
Act Quickly but Not Hastily
While the idea of buying a college condo can be attractive purely from a tax perspective, it makes sense only if you expect to make money on the investment. If you can buy relatively low now and sell high later, you’ll come out ahead. But if you don’t expect to be able to make a profit on a future sale, you may be better off simply paying for your child to live in a dorm or apartment.
The start of school is just around the corner, so act fast if you think this investment opportunity will work for you. Before you meet with a realtor, contact Encore Partners LLP for more information.