Buying a Second Property or Investment Property to Transition to Your Child

Whether your child is heading off to college, beginning their career, or simply needing a stable living situation, buying and owning a second property or investment property rather than having the child rent from a third party can provide long-term financial and tax benefits. Approaching the purchase with a business mindset is critically important to maximizing the venture, ensuring success, and minimizing risk.

Buying a second home or investment property differs significantly from purchasing a primary residence. Lenders may require between 20% to 30% as a down payment to acquire a conventional mortgage. The exact amount depends on a parent’s creditworthiness and the property’s classification (second home vs. investment). If the property is labeled as a second home, it must generally be used by the owner at least part of the year and cannot be rented out year-round. An investment property can be rented long-term, including to a family member, which can then change the lending and tax implications.

Lease Agreement. If the property will be a full-time rental property, a formal lease agreement should be considered to manage the terms of the arrangement. Some common terms considered within a rental contract include:

• Should the arrangement be a long-term or month-to-month lease?
• Should a security deposit be collected?  How much should it be?
• Will there be utilities, repairs, and maintenance to manage, and who will be responsible for what?
• Will you pay the property taxes? What about the homeowner’s insurance, which is often higher for investment properties? And are HOA dues applicable?
• Will you hire a property management company?
• Can the adult child sub-lease or add another tenant, and if so, under what circumstances?

It would be advisable to have a well-drafted rental agreement in place to manage expectations, dictate the handling of expenses and maintenance costs, and troubleshoot potential future issues.

Tax Planning. From a financial planning perspective, rent payments are reported as net income on Schedule E of your Form 1040 after accounting for business expenses and deductions. The arrangement must be arm’s-length in nature to maintain the tax benefits of having an investment property. 

This means the agreement should have terms resulting from both parties acting independently and working in their best interests, as you commonly would have when negotiating with a third party. A formal lease agreement is necessary where the child must claim the property as their principal residence, and rent must be charged at fair market value (FMV), which equates to the going rental rate for a house with similar square footage, number of bedrooms and bathrooms, and amenities involved.

Discounting the rental amount can lead to the property being classified as a personal residence, resulting in you losing most rental expense deductions. In addition, the difference between what should be charged for FMV rent and what is actually being charged could be deemed a gift between you and your child by the IRS, and reportable as such on a gift tax return, if the amount deemed a gift exceeds the available annual exclusion amount. Payments and expenses should be documented, and records should be maintained. 

Deductible real estate business expenses should be tracked and can include the following:

• Depreciation is an allowance for exhaustion and wear and tear on the property. Form 4562 can recover some or all of the original acquisition cost and the cost of improvements
• Repair and renovation costs
• Professional costs – fees charged by bookkeepers, CPAs, or attorneys
• Operating expenses can include software, supplies, inventory purchases, tools, etc.
• Mortgage interest (if applicable) and property taxes 

Entity Formation: To further treat the arrangement as a business venture and to reduce personal liability exposure, the parent landlord should create a limited liability company (LLC) to shield personal assets from property-related liabilities. The property title should be transferred into the LLC, and if there is a mortgage on the property, you should contact the lender to disclose that the property is being transferred accordingly. 

An unauthorized transfer of real property with a mortgage lien secured against the property could be considered a breach of contract and result in a Due on Sale Clause invoked by the lender, which allows the lender to foreclose on the property. Be sure to contact your insurance company to confirm the property is properly insured; otherwise, the company may not honor a claim under the policy. An LLC may complicate future refinancing and increase costs, but for asset protection reasons, it is highly recommended.

Contract-for-Deed and Rent-to-Own Agreements: If your long-term goal is for your child to eventually own the property, an agreement can be structured to anticipate a future sale of the property by the parent to the adult child through a Contract-for-Deed or Rent-to-Own arrangement. 

A Contract-for-Deed arrangement is where you have equitable title but not legal title until the contract is paid in full. The ownership transfer is immediate (but equitable), and you bear more risk as any missed payments can void the agreement. 

Taxes and insurance are typically the buyer’s responsibility under these contracts. The buyer will make regular payments to the seller until the amount owed is paid in full or the buyer finds another means to pay off the balance. It is considered a form of seller financing that can be utilized when a borrower cannot otherwise qualify for a conventional mortgage. A typical Contract-for-Deed is about five years long with a balloon payment due at the end of the term. Applicable Federal Rates (AFRs) should be used to legitimize the transaction.

A Rent-to-Own contract typically has the buyer renting the property and gaining the option to purchase at some point in the future. The ownership transfer is delayed until the option within the rent agreement is exercised. 

The risk associated with this arrangement is more evenly split between landlord and renter, but these agreements are often less enforceable because ownership transfer is not immediate. The landlord parent typically retains responsibility for the taxes and insurance until the purchase is made. 

The lease agreement will detail an option fee, how much rent goes towards the purchase, terms for violating the contract, and how the property’s purchase price will be determined. Both the Contract-for-Deed and Rent-to-Own options are flexible, formal agreements with a division of property rights taking place, can be structured to comply with IRS rules, and can result in a solid exit strategy with terms determined upfront.

Purchasing a second home or investment property for your child can be a savvy and rewarding decision when structured properly at inception. Approaching it as a business venture is critical to complying with IRS rules and protecting yourself. Treating the arrangement as a business enterprise also ensures you can take the appropriate tax deductions. 

If the exit strategy is well contemplated at the onset of the arrangement, it can result in an easy transition later. Make sure you consult with Peak Asset Management, as well as outside tax and legal experts, so all professionals are aligned to assist you in fulfilling your objectives.

Jason Foster, Director of Wealth Strategies and Legacy Planning