Buying Mother-in-Law's house??

Question

My wife and I are considering buying my Mother-in-Law's 3 family house in MA. She's retired and no longer needs the tax advantage of home ownership. My wife and I make around $120,000 and have been getting killed on taxes the last few years with an empty nest and no deductions.
 Basically what we'd be doing is an early inheritance. The house is worth around $650,000. My Mother-in-Law still has a mortgage from when she bought out her sister several years ago for around $100,000. We would take out a Mortgage for around $400,000 to pay off my wive's brother (his share of the inheritance) and pay off exisisting mortgage. My Mother-in-Law currently lives on the 1st floor, my wife and I live on the 2nd floor and we rent out the 3rd floor. Are there any downside or hidden traps to this plan?

Jon Holdman · Answer

Please don't fall for this idiocy that's promoted by people with vested interest in building and selling houses.  If you pay out $10,000 in interest and get back $2,800 from the tax deduction you're still out $7,200 you would not otherwise have spent.  Now, if the payments on this house are similar to the rent you're paying otherwise, and the tax treatments makes the situation even better, that's a different story.   But don't fall for this silliness that somehow you're better off if you spend a dollar and get back 28 (or 33 or whatever) cents from Uncle Sam is a good deal.

Buying the house may generate a tax bill for your mother-in-law.  Impossible to say without knowing the numbers involved.  You say its worth $650K.  What's mom's basis?  If its $400K or more, her gain is $250K or less and, assuming she's lived there two of the last five years, she can exclude that gain.  OTOH, if the basis is $100K because she's owned it a long time, she will have a $550K gain, and can only exclude $250K of that.  That means she has a tax bill on the $300K gain.

Sounds like you're thinking you pay her $650K, and get a loan for $400K.  $100K goes to pay off the loan.  Where is the other $300K going?  What about the difference between the $640K purchase price (plus closing costs) and the $400K loan?  Is that in cash?  Your wife's half of the "inheritance"?  Is it that mom gets the remaining $300K in cash plus an IOU from you and your wife for $250K?  Then she gives brother $300K and gives your wife back the $250K in the for of returning the $250K IOU?  Or some other split?

You'll want to be sure the lender understands what's going on here.  They could be very unhappy if they think they're doing one deal and then money (or IOUs) are changing hands between the buyer (you) and seller (mom) without them knowing.  For conventional residential loans, that would be loan fraud if the lender is unaware.

Does mom have other assets?  These payments in cash to brother and property to you are gifts in the IRS eyes.  They far exceed the gift limits.  That's fine, and does not by itself incur any taxes.  But the excess (I think the limit is $12K or $13K this year) is deducted from the amount of exclusion from inheritance taxes.  If this house is mom's only significant asset, shouldn't be a problem.  If she has a million bucks in the bank or other properties, it may create a tax burden later, since this looks like about $500K in excess gifts that will come off the exclusion.

You really MUST see a CPA and an estate planning attorney.  This is a complex transaction with lots of tax issues.

Jon Holdman · Answer

Right now Mom owns the house that's worth $650K.
          Mom has a $100K mortgage on the house, so Mom has $550K equity in the house.  She want's to give this equity to the kids.  Sister wants to end up with 100% ownership of the house.  Brother wants the cash.
          
          A key question is going to be how do you KNOW the house is worth $650K?  I think the only way to know is to do an appraisal.  And since I don't trust appraisals at all, I'd say you'd have to do FIVE appraisals.  Throw out the top and bottom one and average the other three.
          
          Alternatively, use the one the bank does when you go to get the loan.  But its almost certain to be a lowball number and Brother's unlikely to be happy.  The appraisal situation is just horrible right now, which actually just reflects the market.
          
          What I think you're thinking is:
          1) Mom gives house to Brother and Sister, 50/50.
          2) Sister wants to pay Brother 50% of the equity (value less existing debt)
          3) Sister needs to get a loan to pay off Brother and to refinance debt into her name.  (I'm ignoring Sister's hubby.)
          
          To do that, Mom gives a deed to Brother & Sister.  A lawyer will be needed to get this right, but its something like "each having a 50% undivided interest".  A warranty deed would be best.  Then, Brother gives Sister a quit claim deed handing over his 50% interest to Sister.  In exchange, Sister gives brother $275K.  Not having $275K handy, Sister wants to do a cash out refi.  She needs to pay off the existing $100K loan, so the loan amount need to be $375K, plus costs.  Maybe Sister wants a little cash, too.  So, I see the $400K loan.
          
          Now, I gather you'd like that to all happen at once.  That may be difficult.  For one, this appears to be a triplex.  Is it a legal triplex?  Will the city building department and the planning and zoning commission agree its a triplex and that its either in conformance with current zoning or that its grandfathered?  If its grandfathered, does the grandfathering stick if the ownership is transfered?
          
          For another thing you want a loan on a triplex.  You'll have to find a lender who's willing to do that loan.  You'll need to qualify for that loan, which means good credit (at least 720, 750 would be better), and you'll need enough income to cover the note.  The lender probably won't count any rental income, but might, since its been rented for a while.  The lender may want to seem some cash reserves.  Six months PITI in the bank would be a typical requirement.
          
          Finally, many lenders will want to see "seasoning" on your ownership.  That is, they will want to see that you've owned the property for a while.  For a cash out loan, a year is often a requirement.
          
          So, finding a lender who will do this loan may be a challenge, and finding one who'll do it at the same time you take ownership may be really tricky.  If Brother is willing to take a note instead of getting the cash right away, this may be easier.  So, what would happen is that Mom would make a deed from Mom to Brother, Sister, and Mom.  Now, all three of you own it.  That will typically NOT trigger a due on sale because you're all related (again, lawyer time.)  Brother now gives Sister a quit claim for his fraction of the ownership and in exchange Sister gives Brother a mortgage for the amount brother is owed.  Sister starts paying the existing mortgage payments to the existing lender AND starts paying payments to Brother on the new, $275K mortgage.  Now Sister and Mom own the property.
          
          After a year of ownership, and searching around and finding a willing lender, Sister gets the mortgage. At this point, it MAY not even be cash out, since she's paying off the two existing notes.   With the new mortgage, she pays off the two existing notes and Mom gives her a quit claim for Mom's fraction of the ownership.
          
          Definitely lawyer and CPA time.

Frank McSorley · Answer

Jon, thank you so much for all of the info. This will be a huge help when we talk to the lawyer next week. We are planning on getting a VA loan (I'm retired military). It's definitely a triplex and will remain that way. We just both figure if we are going to do it, now is the time. House prices are way down and 15 year home loans are under 4%. We have oustanding credit so that shouldn't be a problem. Again, thank you so much, you've been a big help. I'll post what we decide to do and how we are doing it once we figure it all out.

Steve Babiak · Answer

Other implications to consider.

Estate Taxes / inheritance taxes - if there is an exemption up to a certain amount, the gain could pass to the heirs after death without any taxes to be paid (up to the exemption); the date-of-death value becomes the new basis for the heirs.

Real estate transfer taxes.  If you have these in your area, the transfer of real property via inheritance is probably exempt from any transfer taxes.  When there is a purchase as you say will happen, there may or may not be exemptions for sale to certain family members.

Frank McSorley · Answer

Jon, thanks for the quick and in-depth reply. This looks like it is a whole lot more complicated than we thought. We are seeing a real-estate/tax attorney next week.What we are looking to do is this:
-Mother-in Law gives the house to her two children. ($650,000)

-Sister buys out brother ($325, 000)minus  half of what is still owed on current mortgage ($100,000/2=$50,000)

-Sister, of course let's mother keep 1st floor apartment, but now 3rd floor rent goes to Sister instead of Mother.

-Sister and husband(me) remain in 2nd floor apartment.

-We pay off house in 15 years and have rental income for retirement.

I guess this is all a lot more complicated than it looks due to tax issues. Sorry, I'm new to all of this. Thanks for your help.

Buying Mother-in-Law's house??

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