Mark emailed me with an interesting scenario in building a house for his parents and renting it out to them. It’s not that his parents can’t afford to build their own, Mike is simply wondering about the benefits and pitfalls of such an arrangement. Here are more details:
My parents are thinking of selling their home and building a new one. They are both in they’re mid 60s and would live in the new house for the next 15+ years. I’m trying to crunch the numbers to see if it makes sense for me to build it for them and rent to them. They would lend me the money from the sale of thier home at whatever interest rate makes the most sense for this plan. I could potentially lose money on the house every year (rent coming up short of the costs) and take a tax write down. At anytime in the future I could sell them the house at cost so as to not incur capital gains. There is more to it but I’m just getting started. Have you ever thought out a senario like this?
- The current house would sell for about $235k with $180k of that being free and clear.
- The new build is estimated at $215k.
- Market rent would be about $1200-$1300. $1500 would not be out of the question for a brand new place.
- I can get money from our banker at prime.
- The rate my parents would charge would be whatever is best for both of us.
The purpose of this would be to try and set up a mutually beneficial situation where we both are better off. The keys would be tax efficiency and cash flow (might be others I have not figured out yet).
There a few key points to think about, that is monthly cash flow, inheritance, and overall cost to the parents.
Let go through each scenario.
Parents Build Themselves
If the parents build a $215k home, they would be left with a $35k mortgage providing they use the equity from the old home (assume no realtor fees). With today’s 5 year rates being around 4.19%, the payments would be about $189/mo over 25 years or $262/month over 15 years. Depending on the financial situation of the parents, paying $262/month +tax/insurance/maintenance is much less than market rent.
Mark Builds and Rents House to his Parents
If Mark were to build the house for $215k and borrow $180k from his parents, he would be left with $35k to either borrow from the bank or cover himself providing he has the cash. Assuming the same rates as above, the bank payments would be the same. That is $189/mo over 25 years or $262/month over 15 years. However, he needs to account for paying back his parents as well. If his parents were extremely generous and offered the $180k interest free with monthly principal payments only, it would be $600/month over 25 years or $1,000/month over 15 years. Assuming that market rent is $1,300/month, the property would be barely cash flow positive over a 15 year amortization (my number one rule). If Mark is determined to make this work, he would need to contribute a large down payment.
An alternative idea not discussed is simply putting Mark on title. Although this would sound like an ideal scenario, it can get a little complicated as there are tax and legal implications. More on this topic on another day as it deserves a dedicated post.
I believe the primary benefit of this arrangement is that Mark would own the house without having to worry about probate fees when his parents pass away (there is no other tax when gifting a principal residence upon death). However, there are many drawbacks. First, the parents would have to pay much more in rent than owning themselves. In addition, even if the parents paid market rent, the investment property is not cash flow positive after taking into account property maintenance, taxes and insurance.
In my opinion, it might be best to simply let the parents build their own house and gift the house to the chlid after passing (via a will). They may face a relatively small probate fee, but no other taxes would be owed *.
* Note that capital gains tax would be payable on the property sale if the house is sold later at a value greater than the value assigned on the date of passing.
Disclaimer: I’m not a financial advisor, anything written in this post should be used for informational purposes only.