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Dr. Don Taylor, CFA, Bankrate.com advice columnistRenting home to daughter

Dear Dr. Don,
My husband and I want to buy a new home. We still owe money on our current home but have enough saved up to pay it off early. We would then like to rent it out to our daughter and her family.

What would be the best thing to do? Pay off the mortgage on the old home or use this money to put down on the new one and have two mortgages with rent coming in to help pay the loans? An answer to this question and any input in general you can give for this situation is welcome.
-- Debbie Decision

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Dear Debbie,
I'd lean toward having a mortgage on the rental property so the interest expense would directly offset the rental income that you receive from your daughter and her family. IRS rules for passive losses on investment property are likely to apply. The IRS publication 'Passive Activity Losses - Real Estate Tax Tips' provides some guidance, but what you decide to charge your daughter for rent is also relevant to the tax implications of this decision.

If your daughter isn't paying a fair market rent on the lease, you'll need to consider whether there are gift tax implications. Since between you and your husband you can gift up to $24,000 per year to any person without gift tax implications in 2007 (other than gifts of future interests in property), it's unlikely that this is the case.

Another alternative is to lease the house to your daughter on a lease-purchase agreement that gives her first right of refusal to buy the house. You can design the agreement so that part of the rent payment goes toward the purchase price.

Converting your personal residence to income property also can have tax implications when you eventually sell the place. Losing the exemption associated with the capital gains from the sale of a personal residence, for example, could create a tax obligation that you could have minimized if you sold the home instead.

However, you can still exclude the gain from the sale of a residence, provided that you have used the place as your principal home for at least two out of the five years preceding the sale, so there's some leeway that would allow you to provide a short-term housing solution for your daughter.

I've given you some things to think about, but my best advice is for you to consult with a tax professional on this matter. There are ways to help out your daughter and her family without her renting your old house.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."

Bankrate.com's corrections policy-- Posted: March 14, 2007
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