When you are over age 55 and sell your principal residence, you can exclude income from up to $125,000 of gain on the home. You must have lived in and owned the home for three of the last five years, though the ownership and residence need not be for the same three years, and you and your spouse must file joint tax returns.
You can use this provision to sell the home to your children or other family members. The buyers won't need to put up any cash or qualify for a commercial mortgage. The sale can be a private loan to the buyer, an installment sale, or a private annuity. In any case you will be receiving regular payments for a period of years or for the rest of your life.
Without moving, you will have turned your home's equity into cash. You also will have removed the home from your estate and transferred it to your children. The children can let you live in the home rent-free. The fair rental value of the home would be a gift from them to you.
An alternative is for the children to charge you fair market rent. If you are charged rent, the children get depreciation deductions and other rental tax breaks. Thus you will have helped them reduce their tax bills. This strategy is extremely flexible and can be adjusted to meet the particular needs of you and your children.
This is a good way for children to put a couple of hundred dollars a month into their parents' hands without tax consequences. All that's needed is for the loan payments to exceed the rent received from the parents, and the parents will come out cash ahead. Since the children will be receiving depreciation and other deductions, their tax savings will enable them to afford the difference.
This arrangement could be subject to the limitation on "passive" losses, but it should be easy for your children to argue that they are actively managing the property and are entitled to loss deductions. At any rate, the tax losses probably will not exceed the $125,000 per year limit on passive losses.
As we discussed in an earlier context, there is another way to use the $125,000: double dip with tax exempt bonds. Use the $125,000 to defer gains on the sale of a home by rolling it over into another home. First you sell your home for cash and buy a new home. But you aren't required to use the actual cash proceeds from your old home to buy the new home. You can make a down payment with some of the cash and take out a standard mortgage for the rest of the purchase price.
The remainder of your cash can be used to buy tax-exempt bonds. The bonds will pay you tax-exempt income that can be used to make the mortgage payments. In addition, the interest on the mortgage payments will be deductible.
About the Author Adam Starchild has been writing on taxes and personal finance for over 20 years. The above article is reprinted with permission from his book How to Save on Your Taxes Without Cheating.
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