Borrowing money then renting to the lender as a tenant - tax strategy

[Ethan Giller]

Hey all,

Here's the situation. I'm planning to move in with my girlfriend in a new city and we're thinking about buying a property instead of renting. I'm thinking about buying a cheap "fixer upper" that has sat on the market for a while and I can put some sweat equity into during the three years that we will be in the location.

For sake of this example, let's assume the following:
-I already own a house nearby that I rent out 4 of the 5 bedrooms and would keep that as my primary residence for tax purposes.
-Both of us have enough cash saved to purchase a $150K house with no mortgage.
-We are planning to live in the property together.
-I'm looking to maximize our joint return, not to maximize my personal savings.

So here's scenario 1 (standard):
I buy a house for $150K and I pay:
$10,000 in yearly repairs and maintenance.
$4,000 in real estate tax.
$3,600 in utilities.
$1,500 in homeowner's insurance.

She pays:
$0

Total cost to us both = $19,100

Scenario 2:
I buy a house for $150K using a loan of $100K from the girlfriend, paying her 10% annual interest. I rent out the property to her for a monthly rent of $1,200. Since my primary residence will be elsewhere, I can depreciate the entire property and show all income & expenses on a Schedule E.

So I'm now paying:
$10,000 in yearly repairs and maintenance.
$10,000 in interest
$4,000 in real estate tax.
$3,600 in utilities.
$1,500 in homeowner's insurance.

And receiving:
$14,400 in rent.

Total cost to me = $14,700

She's paying:
$14,400 in rent.

She's receiving:
$10,000 in interest

Total cost to her = $4,400

Total cost to us both = $19,100

So far these are the same. However, once you consider the tax implications...

She pays tax on the $10,000 in interest.
Total additional cost to her = ~$2,500 (25%)

I show a rental expense of $14,700, minus depreciation on the property ($100K after subtracting land value = $3,636 per year for 27.5 years) = $18,300 loss = tax savings of ~$4,575 (25%).

Total cost = $15,500 + $2,500 - $3,675 = $17,025
Thus, total savings over scenario 1 = $2,075

The question is... what am I missing? Property is rented at market rate, and loan rate is on the low end for a hard money loan. But I'm concerned that if this Schedule E was audited it might be a problem that the lender is the same party as the renter, so the transaction isn't at arms length even if the rates are reasonable.

Any opinions, drawbacks, or things I'm not considering? Sorry if it's confusing, it would be easier to show all of this in table format.