Taxes and partnering in a real estate deal

Dear Tax Talk,
I am planning on buying a home to live in and renting out my current home of three years. I am asking my sister to put 20 percent down on a new home, and become joint tenants with 50-50 ownership, thus avoiding PMI (private mortgage insurance) and getting a better rate on a 30-year loan.

My offer is to let her split the interest deduction each year 50-50. I will make all the payments (PITI, etc.), and then when we sell, split the gain.

Will the gain be tax-free since I will have lived in it as a principal residence though she will not have? Can we split the interest deduction as planned?
-- Mike

Dear Mike,
It sounds like a plan, but I don't think your sister would be entitled to the interest and tax deductions since she is not paying them. On a joint obligation, each person is entitled to claim a deduction of interest for the actual amount paid. Since your sister is not making the payments, she would not be entitled to claim the deduction.

Your payments would not be considered a gift to her, as you are actually making the payments to satisfy your obligation. If she wants to secure a deduction, then she should make half of the payments.

If you actually split the proceeds with her on the sale of the property, then she would be taxed on one-half of the gain. Since it was not her residence, she would not be entitled to the exclusion on the sale of your residence. If it was your home for two years and you did not split the gain with her, you could claim the exclusion on the full selling price. You might later feel like making a nice gift to her to compensate her for her generosity. However, I wouldn't tie the two too closely, as the IRS may frown on it.