How would this not work?

Question

Let's say you owned a house, your brother owned a house, your sister owned a house, and your parents owned a house. If each person quitclaim deeded their house to the next family member so that another family member owned their house, so no one no longer owned the house they live in and then paid "rent" to the family member that now owned the house, how could each person that owned the new house not claim the house as rental property and then claim depreciation on their taxes?

Answer 1

This would be stupid, as all of the rent subject to income tax, you would be paying tax on your mortgage payments w/o the actual money in hand. Also, you now need an investment loan, regular mortgage are owner occupied and your homeowners insurance just tripled.

Everyone claims depreciation if that is the case when they sell, you can do it as a family home.

Answer 2

In theory it could, HOWEVER you MUST charge market rent to be able to take any deduction for the expenses against the rental income. You also need to keep in mind that when you do sell the depreciation allowed OR ALLOWABLE (emphasis mine) is subject to recapture and is taxed even if the sale would otherwise qualify for the exclusion on sale of a personal residence.

Also, there's the issue of having to file Gift Tax returns if the value of the home exceeds $12,000. Today, that's a virtual certainty. If any have used up their lifetime exclusion then gift taxes may be due. Additionally, each party to the transfers would receive the pass-through basis from the donor so there would be no saving of capital gains taxes when they eventually sold.

Lastly, if the IRS sees this as a scam to avoid taxes (and they almost certainly would -- remember the Gift Tax returns!) they would declare the whole thing a sham transaction and disallow any deductions claimed.

Answer 3

what would be your basis in the property that you want to claim depreciation on?


***
IRS has seen this circular rental scheme before.

Yes, they may not detect it at first. However, when they do, all of the accumulated deductions will be disallowed since the transactions lack arm's length economics. Then back interest and penalties will be assessed. Then charges of income tax fraud will be brought.

At the sentencing, you'll all lose the houses.

that might not matter to some, as they could be living in government housing in Las Vegas. It isn't married housing and isn't a good place to raise children, not that the child welfare authorities would let you.

And, you can't visit the casinos from even minimum security prison.

***
btw, you'd lose the exclusion of capital gain when you sell the house, too. so that adds more taxes on at the end.

PLUS, the capital gains tax is figured on the depreciated value, not your 'cost', AND any accelerated depreciation is recaptured (taxed) at ordinary income tax rates.

***
since you exchanged value [house] for value [house], imo Gift Tax would not apply. However, your basis in the property received would be your basis in the property you exchanged, so you could not depreciate based on the market value at exchange date, but only on what you actually paid for the property.

alas, this tax free exchange could cause you to file form 1031 [Tax Free Exchange] which might well cause IRS to look into the matter in the first year -- especially if the exchanging parties appear to be related because some of their names are similar !!

***
unless there is a forced payoff or interest escalation clause in the mortgage [not common], you'd not have to refinance and could keep the existing mortgage and interest rate.

note that refi on an investment property is a taxable event if you take out more money than your remaining basis.

***
lots of pitfalls ... lots

Answer 4

Some excellent answers above. I just want to add, what happens when one of the parties divorces? Your sister in law will end up with your house. A depreciation deduction is not worth it. There are probably wiser ways to accomplish the same thing. You could create a family trust . . . just thinking out loud here.

Answer 5

In addition to all that has been said before, if you have loans on these properties, the "due on sale" clause would kick in and the lenders would call the loans. Any change in title would cause that to apply, so don't even consider this if you have loan(s)