Selling a co-owned home

[Seb13blue]

Hello, my husband and I are looking to buy a home soon, however TK qualify for a loan my in-laws will have to co-borrow with us and have their name on the title. My husband and I are going to be the only ones living in the house. I am just wondering what the tax implications would be for my in-laws when we go to sell the house since they won’t be living in it? Would they be exempt from paying capital gains on the house if we pay for the downpayment as well as the mortgage and other fees? Or would they still have to pay capital gains if their names are on the loan/title?

[Mike9241]

since the sale would likely be some years in the future and tax laws are constantly changing, the answer we give today could be completely wrong in the year of sale.  re-post your question in the year before the sale.

why do they need to be on the title? to a financial institution being a co-signer on the mortgage should be sufficient. 

if they do end up on the title, what's their ownership interest? 

[Seb13blue]

I realize that the laws will most likely be different, but I am interested in knowing what they are now, because we would only be living there for about 6 years and it effects whether or not my in-laws are willing to co-borrow with us.

The reason they need to co-borrow with us is that we don’t have a high enough income to meet the debt to income requirements to qualify for a loan. We have talked to 3 separate lenders and each has said that having them listed as a co-signer would not be enough to qualify us. We do have enough saved up to put a good sized downpayment on a house, but since my husband is still in school we don’t have enough of a combined income to qualify for a loan on our own.

[jtax]

I have seen many lenders require all borrowers be owners of the property. I think that is common.

To answer your questions about capital gains, the first thing to understand is that all income is taxable unless there is a specific exception.

tax code section 121 https://www.law.cornell.edu/uscode/text/26/121 has an exception for gains from the sale of a house that "has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more."  There are lots of modestly-complicated rules about what those terms mean and the time periods that qualify.

But for your purposes it is the "and used by" that clearly means your in-laws do not get to exclude the $250k (single)/$500k (joint) exclusion of section 121 unless they live in that house for a qualifying period. 

However you could speak to an attorney about how to structure the deal.

You could buy the house in an LLC that you all contribute to in different % and get out different % (i.e. they put in money, but you make all the payments and keep up the property and you get out all the capital gain upon a sale). Or perhaps easier is that you just have an ownership contract that says who puts in what and who gets out what.  The lender might not like the LLC but probably doesn't need to see the ownership agreement.

It is possible (but maybe not) that they could by only a small amount of the property (e.g. 1% not 50%). then their capital gains might not be so large. If you want to be sure the in-law's get their money back on a sale (or your deaths) you could enter into a contract to pay them back the full amount invested but no gain. (Or some gain) and you would legally be liable to do so. If your deaths are an issue there is always life insurance.  

You they could own a larger % but immediately sell it to you under a "contract for deed." (That might trigger a due on sale clause on the mortgage, so it probably doesn't work).

But you need a savvy attorney who knows your state real estate laws and tax law ... you might not find that in one person.

[Carl]

What I've seen done is this type of setup, is that the co-borrowers who have no "real" interest in the house, sign a quit-claim deed about a week before the property is sold.  Are you breaking the mortgage agreement by doing that? Most likely the answer is yes. By the time the bank gets wind of this (which they will immediately after the sale closing) it's a done deal, the property is sold and the bank has nothing to gain by "going after" anyone for potential breach of the loan agreement. 

Now how that would work if you live in a community property state, I honestly have no clue if that would even matter.

[jtax]

[Edited]

And what is the consideration for the quit-claim deed? Why bother if the interest is nominal? Why not keep it simple and have all the owners close.

If it is less than FMV of the in-law's shares then the bargain-sale rules apply. Part of the sale would be gift, part income. The FMV of the in-law shares 30 days before the sale had better be almost exactly the sale price 30 days later. Given the amounts involved in houses (especially for example in CA) gift tax returns would probably be required.  Also the IRS might try apply the or sham-transaction step-transaction doctrines because you appear to be shifting income from one taxpayer to another without an economic basis. That seems dangerous to me.

It feels much better to figure this out at the beginning. Figure how how to split up the gain before there is a gain based at least loosely on who puts in what.

In this case given that the in-law's are not putting anything in (the kids have the down payment) I don't see a problem with the in-law's owning a nominal part of the house (1%, .1%) and seeing it all the way through to the end. A .1% interest in a capital gain can't be that large. Even a $1M gain is $10k. Don't like that make it .01%.

[TomD8]

Bottom line: no matter how the ownership is structured, in order for any owner to qualify for the capital gain exclusion the residence requirement must also be met.

The requirement is that during the 5-year period ending on the date of the sale or exchange, the property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.