Buying Home From Parents and Leasing Back to Them

[Martin Fletcher]

Recently my wife and I purchased her parents home and leased it back to them. I think the process we went through and the structure we ultimately followed may be of interest and perhaps help to others so I will summarize it here.

My wife's parents were approaching retirement. Even though they had worked hard their entire lives, they still owed a substantial amount on their home and it would not have been possible for them to start retiring and still service the mortgage. When they explored selling the house and leasing a different place, they found that the cost to rent a comparable property or even something close was going to cost at least as much as the mortgage on their current place. Thus, selling and renting a comparable place would not have improved their cash flow for retirement.

My wife and I wanted to help and began exploring the options.  One option would be to simply give then the funds needed to service their current mortgage so that they could retire and stay in the home. Another option would have been to help pay their rent for a new place.  The problem with helping make the mortgage payments is that any equity created would be in their estate and potentially subject to claims of medicaid liens should they have health issues later in life and eventually need to move into a nursing home.  The problem with simply helping pay rent for a new place is that it creates no equity.  So, two problems, the equity created by paying the mortgage might be at risk from future medicaid claims and simply paying the rent creates no equity.

The solution we came up was to buy their house and lease it back to them at a rental rate that was something they could afford as they retired but less than the mortgage and less than the cost of leasing a comparable property.  This would meet their cash flow needs, allow them to stay in their existing home, and as we covered the difference between the mortgage and the rent, we would grow equity that could eventually go to my wife and I, rather than some future potential medicaid reimbursement claims.

In buying the property we also looked at how to maximize the tax advantages of this structure. We understood that because we were renting the property for less than fair market value, we may be limited in the expense deductions we can take on the property. We assumed that we could deduct the expenses to the extent of the below market rent. The interest payments, depreciation, insurance, and property taxes would exceed the rent and as a result the tax advantages of the transaction would be significantly limited.  Our solution was to buy the property by borrowing against our existing home rather than taking a mortgage on the new investment property.  This way the mortgage interest deduction would be run under our existing home and should be fully deductible, notwithstanding the below market rent on the investment property. The remaining deductions on the property--depreciation, insurance, and property taxes--would then be available up to the full amount of the below market rent received. As a result, we could deduct both the interest used to finance the purchase plus all other normal deductions up to the amount of rent.  

So far the transaction is working as planned: My wife's parents were able to start phasing in their retirement and have the cash flow to stay in their original home. My wife and I were able to finance the purchase in a tax advantaged way that will build equity for us over time.  

This summary is not intended as legal or accounting advice to anyone with respect to their particular situation.  Individual circumstances may be unique, the rules may vary from State to State, and anyone considering these matters should contact their own professional advisors, elder law attorney, and accountants before undertaking a similar transaction.  I do hope this summary provides food for thought to those similarly looking to help parents as they approach retirement.