Published Tuesday, August 30, 2016 at: 7:00 AM EDT
Will your child be packing up soon to go to college? If he or she doesn't have a place to live on campus, you might take advantage of a unique tax-saving opportunity.
If you can afford the cost, you could acquire an apartment building near the school and let your child live in one unit while you rent out the others. If it's a sound investment, you'll make money in the long run, especially if you eventually sell the building at a profit. What's more, your current income from tenants may be subject to favorable tax rules—as could a future sale of the property.
Rental income is taxable, but it may be offset by deductions for expenses such as mortgage interest, property taxes, maintenance, insurance, and other costs, and you also can take a generous depreciation allowance. In some cases, you even may be able to deduct a loss from the rental activity, although this is complicated by "passive activity loss" (PAL) rules.
Those rules stipulate that losses from passive activities incurred during a tax year generally can't exceed your annual income from passive activities. For instance, if you have a passive interest in a business, the income from the business may soak up a loss associated with real estate that you own, but no more.
Rental real estate is treated automatically as a passive activity (unless you're a real estate professional), but you may qualify for an exception. A PAL from rental real estate may offset up to $25,000 of nonpassive income from other sources (wages from a job, for example) if you actively participate in the activity. To qualify, you have to be involved in making management decisions for your property—arranging leases for tenants, supervising repairs, and so on. The $25,000 allowance is phased out for an adjusted gross income (AGI) between $100,000 and $150,000.
Suppose your AGI is $100,000 and you buy a duplex near your child's campus. Your child lives in one unit and you rent the other to another student. For simplicity, we'll assume that your first-year depreciation deduction under the IRS tables is $10,000 and you incur $20,000 in deductible expenses. You charge the student $1,000 per month, the going rate in the neighborhood, so you're showing an annual loss of $18,000 ($30,000 minus $12,000). Based on your AGI, you can use the entire $18,000 loss to offset highly taxed income.
After your child graduates, you may decide to sell the place. Icing on the cake: The maximum long-term capital gain rate is only 15% or 20% if you're in the top income tax bracket. Overall, it's a pretty good deal.
This article was written by a professional financial journalist for The Hogan-Knotts Financial Group and is not intended as legal or investment advice.