Residential Sale Leaseback

I read your article in bottom line personal on ways to finance retirement homes. How do you enter into a sale lease back with a grown child? I could only find info on leaseback with commercial property on the web. Could you help me? Thank you. P. S. I enjoyed your article very much.

A saleleaseback for a residence is really similar to that for a commercial property. Let's first define what it is and why you might do it then we'll address some of the differences.

A sale -- lease -- back is simply a transaction in which you sell real estate, in this case your house. That should be done with the same formality as any sale of real estate. This would include a sale contract, title insurance, new property insurance, etc. Then you lease the house, this would include a lease agreement, in your case a residential lease. The "back" part of the sale leaseback is just that you as the seller are also the person leasing the property back to yourself to use.

In any sale leaseback the fact that the seller is leasing the property means that you're on two sides of the transaction which will cause greater IRS scrutiny. That means you should not only be more careful to document the transaction, but that you might want to take additional precautions to demonstrate that the transaction is real. In the case of a sale leaseback to a family member you should absolutely take even more precautions. The IRS is apt to review the transaction to be certain that the prices of the sale and rental are fair (arm's length). You could for example hire an independent real estate broker (an appraiser would be better but a certified appraiser will add more cost) to provide an appraisal of the house to support the sales contract. You could hire an appraiser, or broker to keep the cost down (but with less authority in the event of an audit), to provide written corroboration as to the value of the lease.

In a residential sale leaseback the contract of sale should be the same type of document that would be used if the seller were selling their house to an unrelated buyer. The lease document should be the type of residential real estate lease which an unrelated landlord would use to rent property to an unrelated tenant. There are commonly used standard forms by lawyers in most parts of the country (every state has its own forms) that might be a good starting point. Using standard forms in a family transaction is a good way to show independence for tax purposes. Howevever, as with any standard form, be sure to review them carefully with a local real estate lawyer to tailor them to your situation.

Once this part of the transaction is understood, you also have to carefully consider the tax consequences. Does the seller qualify for the home sale exclusion? That would enable a single parent to exclude $250,000 of gain or if married perhaps $500,000 on a joint return. Great tax benefit, but also a reason the IRS might look more closely at the transaction. If the property is undervalued it could be a gift to the child. If the property is overvalued is it just a sham to step the basis up higher so the child will avoid future capital gains at no cost to the parent seller? The child will then have a rental property and will have to depreciate it and report the rental income as income on his or her personal tax return, schedule E. There are lots of nuances and complications to all of this and you need the help in advance to plan this with a tax accountant.

Next, give some thought to liability. Should the child have the house owned by a limited liability company (or perhaps another entity) to limit liability? Even though it is a parent, that might be helpful.

Insurance issues need to be addressed. The house, to the child/buyer/landlord is a commercial property and should be insured as such even though a parent is renting it. Consult with a competant insurance agent. You would not want to jeapardize coverage by misclassifying the property.

As with all "simple" sounding questions there can be a myriad of tax, legal and other issues that all need to be addressed. This is why you always should consult with professional advisers before entering into even a transaction that sounds simple. It might not be.