Prices are booming on many residential property markets, including university towns. Is It Too Late To Benefit From It? Maybe not.
The idea of buying a condo for your college kid to use while in school could be tempting. But getting into the market sooner rather than later can be smart. You could avoid paying for a dorm room or apartment with no hope of profit. And if you buy a condo with a little more space, you can rent it out to your child's friends and offset some of the cost of ownership. Nice.
Many parents have made good – sometimes great – money following this strategy for the four or five or (pant) six years their kids spent in college. Of course, the longer you can keep the property, the better the chances of paying off a nice profit. You don't have to sell just because your child graduated. Another important factor are the tax aspects. This is how it works while the child is still in school.
Deduction of the cost of condominiums at the university
State income tax regulations generally prevent you from deducting losses incurred in owning and renting a home that is more than little used by you or a member of your immediate family.
A favorable exception, however, is if you rent at market prices to a family member who uses the property as their primary residence. In this scenario, you can deduct losses from the rental activity – subject to the passive loss rules that I explain later in this column. This advantageous loophole is open to you if you buy a condominium and rent it to your studying child – and possibly roommates – at market prices. (You can see the details in Section 280A (d) (3) of the Internal Revenue Code.)
As long as you charge market rents, subject to the passive loss rules, you can deduct mortgage interest and property taxes and write off all operating costs – including utilities, insurance, club fees, repairs and maintenance, etc. As a bonus, you can over the cost of the condominium itself – not the property Write off 27.5 years, even if it is an increase in value.
But where does your son or daughter get the money from to pay you the market rent for the condominium? The same place he or she would get the money for a dorm room or an apartment rented from a third party. From you. You can give your child up to $ 15,000 annually with no adverse federal tax impact. If you're married, you and your spouse can donate up to $ 30,000 together. Your child can use some of this money to write you monthly rental checks. Just make sure he or she actually sends the checks and make sure they say they are for rent. It's also best if you open a separate checking account to handle rental income and expenses. Following these simple steps can keep the IRS off your back in case you ever get audited.
Passive loss rules can defer tax losses
If the condominium is making annual tax losses – which is likely after taking into account depreciation allowances – the Passive Loss of Activity (PAL) rules generally apply. The basic PAL concept is this: You can only deduct passive losses to the extent that you have passive income from other sources – such as positive taxable income from other rental properties you own or profits from the sale of them.
Fortunately, you can deduct up to $ 25,000 in annual passive losses from rental property if: (1) your annual adjusted gross income (before property loss) is less than $ 100,000; and (2) you “actively participate” in the rental activity. Active involvement means being energetic enough to at least make management decisions like approving tenants, signing leases, and approving repairs. No need to mop the floor of your college kid's condo or wiggle out the drains.
If you qualify for this exemption, you don't need passive income from other sources to claim a deductible rent loss of up to $ 25,000 per year (your loss probably won't be that large). However, if your Adjusted Gross Income (AGI) is between $ 100,000 and $ 150,000, the exemption will be proportionally abolished. So, with an AGI of $ 125,000, you cannot deduct more than $ 12,500 in passive rental home losses each year (half the normal maximum of $ 25,000) if you have no passive income. If your AGI exceeds $ 150,000 and you have no passive income, you are not currently able to deduct rental property losses.
However, any unrecognized losses are carried forward to future tax years and you can deduct them if you have sufficient passive income or if you sell the tax-losing college condominium. All in all, this is not a bad tax result – as long as your losses are mostly "paper" from depreciation.
Favorable tax treatment when selling
When you sell rental property that you've owned for over a year, the profit – the difference between the sales proceeds and the property's tax base after deducting depreciation – is a long-term capital gain. Under current law, the maximum federal income tax rate for long-term capital gains for most people is 15%. However, if you are in the very high income category, the maximum rate is 20%. Higher income individuals may also owe the 3.8% Net Investment Income Tax (NIIT) on long-term profits. Finally, part of the profit – the amount equal to your accumulated depreciation – can be taxed at a maximum federal rate of 25%.
Do you remember the passive losses we talked about earlier? You can use them to offset a profit on the sale of the condo.
Warning: President Biden plans to raise the top tax rate on long-term capital gains to 39.6% plus the NIIT of 3.8% for a combined top rate of 43.4%. Will this idea come through Congress? We will see. Stay tuned.
The bottom line
While buying a college condo is a pretty attractive idea from a purely tax standpoint, it really only makes sense if you expect to end up making hard cash. If you can buy now and sell later for a healthy profit, you'll be glad you made the deal. Of course, that is not certain.
See also: Are 529 college savings plan payouts taxable? In this way you avoid unpleasant surprises