Prices are booming in many residential real estate markets, including college towns. Is it too late to take advantage? Maybe not.
The idea of buying a condo for your college-bound kid to use while in school might be appealing. But diving into the market sooner rather than later may be wise. You could avoid paying through the nose for a dorm room or apartment with no hope of any profit. And if you buy a condo that has some extra space, you can rent it out to your kid’s pal(s) and offset some of the ownership costs. Nice.
Many parents have made good — sometimes great — money by following this strategy for the four or five or (gasp) six years their kids spent in college. Of course, the longer you can hold onto the property, the better the odds of cashing out for a nice profit. You don’t have to sell just because your kid graduated. Another key factor is the tax angles. Here’s how those work while the kid is still in school.
Deducting college condo ownership expenses
Federal income tax rules generally prevent you from deducting losses incurred from owning and renting out a residence that’s used more than a little bit by you or a member of your immediate family.
However, a favorable exception applies when you rent at market rates to a family member who uses the property as his or her principal residence. In that scenario, you can deduct losses from the rental activity — subject to the passive loss rules, which I’ll explain later in this column. This beneficial loophole is open for you if you buy a condo and rent it out to your college-attending child —and roomies, if any — at market rates. (You can dig into the details in Internal Revenue Code Section 280A(d)(3).)
As long as you charge market rent, you can — subject to the passive loss rules —deduct the mortgage interest and property taxes and write off all the operating expenses — including utilities, insurance, association fees, repairs and maintenance, and so forth. As a bonus, you can depreciate the cost of the condo itself — not the land — over 27.5 years, even if it’s appreciating.
But where will your son or daughter get the money to pay you market rent for the condo? The same place he or she would get the cash to pay for a dorm room or an apartment rented from some third party. From you. You can give your kid up to $15,000 annually without any adverse federal tax consequences. If you’re married, you and your spouse can together give up to $30,000. Your child can use some of that money to write you monthly rent checks. Just make sure he or she actually sends the checks and make sure they say they are for rent. Also, it’s best if you open up a separate checking account to handle the rental income and expenses. Taking these simple steps will help keep the IRS off your back if you ever get audited.
Passive loss rules may postpone tax losses
If the condo throws off annual tax losses — which it probably will after counting depreciation deductions — the passive activity loss (PAL) rules generally apply. The fundamental PAL concept goes like this: you can only deduct passive losses to the extent you have passive income from other sources — like positive taxable income from other rental properties you own or gains from selling them.
Fortunately, a beneficial exception says you can deduct up to $25,000 of annual passive losses from rental real estate provided: (1) your annual adjusted gross income (before the real estate loss) is under $100,000 and (2) you “actively participate” in the rental activity. Active participation means being energetic enough to at least make management decisions like approving tenants, signing leases, and authorizing repairs. You don’t have to mop the floor of your college kid’s condo or snake out the drains.
If you qualify for this exception, you won’t need any passive income from other sources to claim a deductible rental loss of up to $25,000 annually (your loss probably won’t be that big). However, if your adjusted gross income (AGI) is between $100,000 and $150,000, the exception gets proportionately phased out. So at AGI of $125,000, you can deduct no more than $12,500 of passive rental real estate losses each year (half the normal $25,000 maximum) if you have no passive income. If your AGI exceeds $150,000 and you have no passive income, you can’t currently deduct any rental real estate losses.
However, any disallowed losses are carried forward to future tax years, and you’ll be able deduct them when you have sufficient passive income or when sell the tax-loss-producing college condo. All in all, this is not a bad tax outcome — as long as your losses are mostly of the “paper” variety from depreciation write-offs.
Favorable tax treatment when you sell
When you sell rental real estate that you’ve owned for over a year, the profit — the difference between sales proceeds and the tax basis of the property after subtracting depreciation — is long-term capital gain. Under current law, the maximum federal income tax rate on long-term capital gains is 15% for most folks. However, if you’re in very-high-income category, the maximum rate is 20%. Higher-income folks may also owe the 3.8% net investment income tax (NIIT) on long-term gains. Finally, part of the gain — the amount equal to your cumulative depreciation write-offs — can be taxed at a maximum federal rate of 25%.
Remember those carryover passive losses that we talked about earlier? You can use them to offset any gain from selling the condo.
Warning: President Biden wants to raise the top federal rate on long-term capital gains to 39.6% plus the 3.8% NIIT for a combined top rate of 43.4%. Will that idea get through Congress? We shall see. Stay tuned.
The bottom line
While buying a college condo is a pretty attractive idea purely from a tax perspective, it really only makes sense if you expect to come out ahead cash-wise when all is said and done. If you can buy now and sell for a healthy gain later, you’ll be glad you did the deal. Of course, it’s no sure thing.