One option in retirement is to sell your house to a grown son or daughter, then rent the house from the new owner. Tax breaks can help such a sale-leaseback pay off. To set the stage, consider the tax breaks you might not be using after you retire:
• If you have been in the house for many years the mortgage may be paid off, or nearly so. As a home owner, you might be getting little or no deductions for mortgage interest.
• Any mortgage interest or property tax deductions you now take may have little value, if you’re in a low tax bracket in retirement.
• Like many retirees, you may not even itemize deductions so you’d be getting no tax benefit from home ownership.
On the other hand, if you sell the house to a child and rent it back, he or she can enjoy the tax benefits of owning investment property. Moreover, you will wind up with cash to support your lifestyle as well as the opportunity to stay in your home.
In many cases, it will be better to sell to one child rather to a group of children. This is likely to reduce disputes among the siblings and other complications. A fair value should be paid for the house, to avoid hard feelings among the other children.
As described above, homeowners can sell a principal residence and avoid tax on $500,000 worth of gain, if a joint return is filed, while single taxpayers get a $250,000 exclusion. If a sale-leaseback is arranged so that your profit falls within the $250,000 or $500,000 limit, no capital gains tax will be due.
Suppose you’re married, with a basis of $300,000 in your house. You can sell the house to your son or daughter for any fair price up to $800,000 without triggering any tax. Then you can keep living in the house indefinitely, paying rent to your child, who has become the new owner.
Be aware that the IRS might claim that the house was undervalued and the difference was a taxable gift. In the above example, if you sell your house to your son for $400,000 the IRS might argue that the house was really worth $600,000 at the time of sale so you gave him a gift of $200,000: the $600,000 value of the house minus the $400,000 selling price.
To avoid this problem, demonstrate the value of a house at the time of the sale by collecting current newspaper listings, showing asking prices of similar homes. For extra safety, get a professional appraisal to support the price actually paid.