02/13/07: Buying Parents Home: Be Careful

Housing Counsel

By Benny L. Kass

Q: I want to purchase a home that my parents own. It has a mortgage in the amount of $250,000 and has been appraised for $499,000. My parents want $200,000 out of it. Should I ask them to refinance and get the money they want and then just arrange to put the house in my name? Or should I purchase the home and give them the money?

I want to put an addition on the property and would like to have money to do this without stressing out financially.

A: We have to analyze this from two points of view: your and your parents.

I do not know what your parents paid for the property, but if they have owned and used it for two out of the five years before you buy it, they will be able to take the entire up-to-$500,000 exclusion. Since the price you plan to pay will not exceed $500,000, it would appear that your parents would not have to pay any capital gains tax.

If your parents refinance the property, how can you be sure that they will get the $200,000 they want? They currently own $250,000, which means that they will have to get a refinance loan in the amount of $450,000 in order to take out that amount of money. And even if their credit is pristine pure, I doubt that a lender would agree to such a large loan.

Furthermore, your parents will have to be concerned about a gift tax. Currently, each of your parents can give you (tax free) up to $12,000 per year. However, if they give you the house, that clearly exceeds the free gift amount and they must determine how this will impact on their own tax and financial situation.

More importantly, if your parents give you the property and you arrange to have the title transferred into your name, your basis for tax purposes will be that of your parents. Let’s assume that your parents paid $200,000 for the property several years ago, and did not make any improvements. Their basis in the property is $200,000. When they give the house to you, the basis of the donor (your parents) becomes the basis of the donee (i.e. you).

What does this mean?

Let’s say you decide to live in the property. You pay $100,000 for a new addition to the home, and stay there for three years. You then decide to sell it for $700,000. Your basis for tax purposes is $300,000 (the $200,000 from your parents plus the $100,000 addition).

Since you have lived and owned the property for two out of the five years before sale, and because you are not married, you are eligible for the $250,000 exclusion of gain. But your profit is $400,000 ($700,000 – $300,000).

In my example, you will have to pay the IRS 15 percent on the $150,000 of profit which is over the exclusion. That will cost you $22,500, and you will also have to pay the applicable state or local capital gains tax.

The next question to ask is whether you can qualify for a loan. If so, in my opinion, you are better off buying the property outright from your parents. Since there will not be a real estate agent involved, you can deduct the 6 percent commission that would normally go to the agent, and still be able to arrange that your parents get their $200,000. Your price would be in the range of $470,000

However, this does not necessarily put any money in your hands for the addition you want to build. So let’s try another approach. Your parents can obtain a home equity loan in the amount of $100,000, and use these funds to install the addition you want. Then, instead of paying $470,000 for the house, you would sign a contract for $570,000. And assuming that you can get a loan for this purchase price, at settlement, the mortgage and the home equity loan will be paid off and your parents will get their $200,000.

This is only an example for your consideration. There are many factors to be considered:

– will you be living in the property or will you be renting it out?

– can you afford the mortgage?

– do you really need the new addition now?

These are the kinds of questions which you must discuss with your financial and legal advisors. But the bottom line to remember: a gift from parent to child is not always in the best interests of either parent or child.