Single Occupancy Homes
One option is to buy a single occupancy home. In this scenario, only the child would reside in the home. The tax implications in this scenario are similar to those of a taxpayer’s primary residence. IRC section 280A(d)(1) defines a residence as a dwelling unit whose personal use is more than the greater of 14 days or 10% of the number of days rented at fair market value. With single occupancy, there would be no rental days, so residence status would be determined by personal use days. Under IRC section 280A(d)(2), personal use days would include any days the property is used by the taxpayer or any member of the taxpayer’s family. IRC section 267(c) (4) defines family to include the taxpayer’s spouse, siblings, ancestors, and lineal descendants. If the child lived in the home while away at college, personal use would exceed 14 days and the home would be considered a residence for tax purposes.
For tax purposes, a taxpayer is allowed to deduct certain expenses for a residence. IRC section 163(h) allows the deduction of qualified residence interest, which is defined as the acquisition and home equity indebtedness of a qualified residence of the taxpayer, subject to certain limitations. A qualified residence includes the taxpayer’s principal residence and one other dwelling unit used by the taxpayer as a residence. In this scenario, the taxpayer’s principal residence would be the home in which the parents live. Based on the discussion above, a second home purchased by the taxpayer but used by their child while at college could qualify as a second residence; therefore, the taxpayer would be allowed to deduct mortgage interest on both the principal residence and the child’s college residence. IRC section 163(h) does, however, place limitations on the amount of mortgage interest that can be deducted. For taxable years beginning after December 31, 2017, and before January 1, 2026, interest expense on aggregate mortgage indebtedness in excess of $750,000 is not deductible.
Taxpayers are also allowed to deduct property taxes paid under IRC section 164(a). Under IRC section 164(b)(6), however, the total deduction for state and local taxes is limited to $10,000 for taxable years beginning after December 31, 2017, and before January 1, 2026. A single occupancy home, purchased for a child to live in while in college, could provide both mortgage interest and property tax deductions for the parents. These deductions would generate tax savings to offset the housing cost. There are no similar deductions allowed if the child is renting a dorm room or apartment.
Another option for parents to consider is the purchase of a home with multiple bedrooms. This could be advantageous if there are multiple siblings attending college at the same time. The tax consequences of siblings sharing a house would be the same as discussed previously for a single occupancy situation.
The more likely scenario would be parents buying a multi-bedroom home for their college-age child and renting the excess rooms to other college students. This would change the tax states from purely a residence, to a residence with rental use. Under IRC section 61(a)(5), rents are included in gross income, so any rent payments by a roommate would be includable in the parents’ gross income. Ordinary and necessary expenses paid during the year for the production of income and the maintenance of the property, however, are deductible under IRC sections 162 and 212. Expenses related to a property that is used both personally and as a rental must be prorated under IRC section 280A and its related regulations. Normally, these properties are used only for one purpose, either personal or rental, each day, and the expenses are prorated based on the number of rental days relative to the total number of days used.
The present scenario, whereby the property is used by a child and simultaneously rented to unrelated parties, presents a more unique situation. In this case, there is both personal and business use of the home on the same days. Treasury Regulations section 1.280A-2(i) (3) provides some guidance, stating: “the taxpayer may determine the expenses allocable to the portion of the unit used for business purposes by any method that is reasonable under the circumstances.” The regulation goes on to suggest, but not require, that a taxpayer could use the percentage of square feet rented or the ratio of rooms rented to total rooms to determine how to allocate expenses between rental and personal. Because the regulations allow the use of any reasonable method, taxpayers have some leeway in how they allocate expenses and its effect on their tax liability.
Depending upon the amount of expenses deducted, the rental activity could generate net income or loss. Rental activities are considered passive activities for income tax purposes. Taxpayers are only allowed to deduct passive losses against passive income. If the taxpayer has no other passive activities, a loss from the activity would not be deductible. Under this scenario, a taxpayer might want to consider allocating less expense to the rental use and more to personal use (assuming these expenses are largely mortgage interest and taxes that are deductible personally). There is an exception that allows certain taxpayers to deduct rental losses against ordinary income. IRC section 469(i) allows taxpayers with AGIs under $100,000 to deduct up to $25,000 of passive activity losses, even if they have no passive income.
Net income from a rental activity presents different tax implications. As discussed above, rental activities are considered passive, so any net rental income would be passive income that would allow a taxpayer to deduct losses from other passive activities. Rental income may also subject to the 3.8% net investment income tax under IRC section 1411, but only if the taxpayer’s AGI exceeds certain thresholds ($250,000 if married filing jointly; $200,000 otherwise).
Consider the Benefits
In addition to the tax benefits of mortgage interest and property tax deductions, the potential increase in the value of the real estate can provide an offset to student housing costs that is not available if the student is renting. Additional revenue from the home’s use as a rental property can further offset housing costs. Taxpayers would need to consider their individual tax situations to determine the best course of action. Some parents may prefer a single occupancy home that can provide interest and property tax deductions and value appreciation without the work that comes with being a landlord. Other parents may use the rental option to provide their college student with the additional real-world experience that would come from serving as the property manager of their rental home. With proper understanding and planning, the purchase of a second home as a residence for a college student can be a worthwhile investment.