# Family tax planning



## nbw (Oct 31, 2010)

I was at the bank today to discuss options for financing a plan I have to build a new house for me to live in on land owned by my parents. The bank told me that I will need to get a line of credit, and suggested that my parents are probably the only people who would qualify at this stage for the money. The bank suggested that this could have some tax advantages for my parents, depending on how the project was structured. I have done some reading this evening and suspect the bank was talking about deducting interest on investments. I'm going to need to 'sell' this idea to my parents so I'm hoping to get enough information before I go to them.

Here's how I would envision the project working:

1. My parents take out a line of credit (or mortgage?) to build the new house using their own home as collateral.
2. My parents make monthly payments on the line of credit, these payments having a mix of interest and capital.
3. I would then pay my parents rent equal to slightly more than the monthly payments that they need to make.
4. My parents deduct the interest paid from their income tax.

Assuming the interest payments are somewhere between $20-30,000, and that my parents have combined income exceeding $200,000/yr, would this mean that my parents could deduct the $20-30,000 from their income? Would this be at their marginal tax level, so about 48% of $20-30,000 back in their pockt each year over the life of the line of credit?

What am I missing here? Is there some arms-length provision I'm missing??

I suspect my parents would go for the whole idea if they could pocket upwards of $10,000 per year for their troubles, so I am hopeful my read on the situation is somewhat accurate.

Thanks for any help, suggestions or pointers you may have.


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## FrugalTrader (Oct 13, 2008)

So basically, your parents will build a rental property and have you as a tenant. Will it be a problem that you will be renting from your parents and have no ownership of the property?


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## nbw (Oct 31, 2010)

Not really, since the property will be left to me in their will. I intend to take out life insurance to pay the expectedly whopping capital gain.


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## MoneyGal (Apr 24, 2009)

nbw said:


> What am I missing here? Is there some arms-length provision I'm missing??


What you're missing is the other end of the equation: as they deduct the interest paid, they would also need to report the income earned. In the setup you've described, they do not decrease their taxes, they increase them. 

As an important aside, in order to maintain the deductibility of the interest expense, they *must* charge you more than their costs, particularly as you have a non-arm's-length relationship with them. That is, in order for the interest to be deductible, there must be an expectation of profit in the arrangement. 

It might be more straightforward for you simply to repay them their costs with no deduction on their part. In this way it is a wash for them. (This solution leaves aside the question of your ownership position, which FP raised.)


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## nbw (Oct 31, 2010)

Right, so that was what I was missing. Thank you for pointing that out!!

Any idea what the bank was talking about then as a tax savings? Would there maybe be a tax advantage if we formed a corporation to hold the land/house??


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## ghostryder (Apr 5, 2009)

nbw said:


> Any idea what the bank was talking about then as a tax savings?



Suggestion: Don't take tax advice from a bank.


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## FrugalTrader (Oct 13, 2008)

I don't see any tax advantage of holding the property within a corp. Any rental income within a corp is considered passive, thus taxed at the highest corporate rate. That doesn't include the extra costs of forming and maintaining a corp.


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## MoneyGal (Apr 24, 2009)

I wonder why there seems to be a rash of people asking whether incorporation is the solution to perceived tax woes, particularly in respect of real estate. Hmmmm.


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## nbw (Oct 31, 2010)

If my parents formed a partnership (with an eye to making a profit from the eventual sale of the property to me) or even if my dad did this as a sole proprietor, and if I didn't pay them rent (so they have no income from the property), would the interest paid on the line of credit be a loss which they could flow back to their own income? How do rich people form mining partnerships and have the start-up costs of building the mine offset their personal income to near-zero??

Or is this whole concept basically a non-starter and the bank was simply mistaken that there may be tax advantages to my parents holding the line of credit?? Are we simply not rich enough, or big-scale enough, to get some tax savings here???

Thanks!!


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## MoneyGal (Apr 24, 2009)

Rental income is a whole different ball game than flow-through shares. 

As for what your bank was suggesting; who knows? Sounds like it may have been something tossed off as a lure. This isn't a matter of scale.

Be very, very careful with non-arm's-length relationships. If your parents built a house and you occupied it at no cost to you, their deduction would need to be decreased by the FMV of the rental cost. They *could* arrange their affairs so that they pay down the line quickly (and thus have costs exceeding the FMV of rent), but the whole arrangement is subject to increased scrutiny because of your relationship.


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## nbw (Oct 31, 2010)

So... I guess I'll need to hope that my parents have enough confidence in me to put their house behind a line of credit for my benefit, with nothing substantial coming back their way 

Thanks for all the help!


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## MoneyGal (Apr 24, 2009)

I'm glad it seemed like help and not like snippy Internet commentary (speaking strictly about my own contributions). 

It may be helpful to you to actually build a mathematical model (just in Excel; nothing fancy) to test whether there are any scenarios in which your parents come out ahead. 

I am sure there are, but I suspect they are on the edges of the model. So, for example, if you built a model, you might be able to conclude "this could work but only if conditions a and b are met" - that would give you a little more concrete stuff to work with.


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