Sometimes investors find themselves in situations resulting from making uninformed decisions many years before. We recently worked with an investor who jointly owned her mother’s home. Nearly 20 years ago, it was likely a viable solution adding the daughter’s name to the mortgage, establishing joint ownership, and ensuring that the daughter would inherit the house.
Fast forward two decades, the house has nearly quadrupled in value, and her mother passed away. As the investor was on the mortgage, she had Joint Ownership with Rights of Survivorship, meaning when one of the parties dies, their share of the property passes to the surviving owner(s). However, since this was real estate, it was included in the mother’s estate, which received a step-up in basis. Although the wish for the house to go to the daughter was ultimately fulfilled, there is a potential tax issue—if the daughter were to sell the house, she would likely face a significant capital gain on her portion of the ownership.
To defer the capital gains, the daughter decided to keep the house as an investment property, renting it to her cousin’s family at fair market value. Today, the daughter wants to sell the property, and the cousin wants to buy it. The issue is the tax impact.
Given their unique set of circumstances, they could complete the transaction as an installment sale. If the daughter sells the property for a reasonable down payment and carries the note herself, she should only owe income taxes on the portion of the down payment and any principal payments received in the year of the sale that represent taxable gain. Additionally, she can collect interest on the remaining note balance at rates near what a bank charges. To qualify as an installment sale, she must receive at least one payment after the year in which the sale occurs.
This approach benefits all parties as the investor can control the capital gains, and payments on the property would generate cash flow for the next few years, aligning with her financial plan. Additionally, since the buyer is family, the investor considers the risk of default low, and the installment sale provides the cousin with a more affordable interest rate than a traditional home loan.
When entering into nontraditional agreements like this, it is advisable to have a lawyer draft a contract, putting all terms in writing. The contract should include a fixed schedule for repayment and specify that real estate serves as collateral for the loan. There should also be an amortization schedule and terms for early payoff should the buyer decide to purchase the property outright.
The loan must charge a minimum interest rate equal to the applicable federal rate (AFR) based on its term to keep the IRS from treating the transaction as a gift. The IRS publishes the AFR monthly as a Revenue Ruling, easily accessible online at IRS.gov by searching “AFR.” It is crucial for all parties to maintain records of repayments to further substantiate that the loan is not a gift.
When past financial decisions affect your current situation, it is always best to consult professionals, like a CPA or financial adviser, to review your circumstances and provide insights into how they may affect your future. If you have questions on capital gains or selling an appreciated asset, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the June 3, 2023 “Henssler Money Talks” episode.
This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
