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So You Want To Add A "Mother-In-Law Suite"?

Written by on Sunday, 22 July 2001 7:00 pm

Question. My husband and I have lived in our house for many years, but now it's too big for us. Our daughter and her husband have suggested that we sell them the house, construct an additional room to it, and then we can live in the new addition. We would add approximately 900 square feet to the home, and move into that portion of the house. We like this idea, so that we can be close to our family and especially our grandchildren.

We would finance the construction because the equity in our present home would be more than enough to cover the cost.

What is the best way to proceed in order to protect everyone's interest? We assume that a written agreement is needed, but what should be included in that document?

Answer. You are wise to be thinking about entering into an agreement with daughter and her husband. Even in the best of families, problems and difficulties occur, and it is always important to draft -- and sign -- a written agreement now while you are still talking to each other.

Your question must be answered in two parts: the tax issues, and the other legal issues.

First let's look at the tax issue. Since you have lived in the house for a number of years and used it as your principal residence, if you file a joint tax return, you will not have to pay any capital gains tax on the first $500,000 of profit. Keep in mind, however, that if you had previously "rolled over" profit from the sale of another house to purchase your present home, the profit you then deferred must be considered in your determination of "profit."

Let's look at this example. Many years ago, you purchased your first home for $30,000. You subsequently sold it for $100,000, thereby making a profit of $70,000. However, under the old (pre- l997) tax law, when you purchased your present home for $150,000, you were able to "roll-over" this profit, thereby deferring -- but not avoiding -- having to pay any capital gains tax on this profit.

Although you purchased your new property for $150,000, in fact the tax basis of your new home was only $80,000 ($150,000 - $70,000). It should be noted that for purposes of this article, I am ignoring such items as improvements, closing costs or real estate commissions. When you start analyzing your specific tax situation with your tax professional, all such items should be included, so that your capital gains tax would be reduced.

Now you plan to sell your house to your daughter and her husband. The agreed upon price is $650,000. Although you purchased the house for $150,000 -- and thus believe that your profit is $500,000, in fact in our example your profit is really going to be $570,000 ($650,000 - 80,000). According to current tax computations, you will have to pay a capital gains tax on the amount over $500,000 -- which is $70,000. The federal tax will be approximately $14,000.

Here is where you have to sit down with your tax advisor and a calculator to determine what is the best strategy for you. You have indicated that you would be financing the construction of the addition. What tax bracket will you be in and are there advantages to having your daughter and her husband pay the financing so that they can take the additional interest deductions?

Or is it in your best interest to pay for the improvement yourselves, thereby increasing your tax basis and possibly avoiding having to pay any capital gains tax. In our example, if the addition will cost you at least $70,000, this will decrease your profit and thus you will pay no tax.

There are a number of possible scenarios. For example, you could lend your daughter the money and she would pay you interest, just as if you were a bank. While this interest would be income to you, under current tax laws, if your daughter and son-in-law give you a recorded deed of trust, it would be fully deductible by them in whatever tax bracket they are in. However, under this approach, you may not obtain sufficient moneys to do the construction.

You may also want to consider giving a gift to your daughter and her husband, and they could then construct the addition using these proceeds. The tax consequences should be explored, before you make the determination of how to proceed.

The other legal issues raise a number of questions, all of which should be explored -- and resolved -- before you proceed with your plans.

  • What happens if you find that you and your wife cannot live in your daughter's home?

  • Who owns the addition?

  • How does zoning impact expansion of the property?

  • Will you be charged rent for living in the addition, and if so, how much?

  • Who will pay any increase in utility costs and real estate taxes created by this new addition?

  • What happens if you decide to move out?

Additionally, do you have any other children? And are you properly protecting their interests after your death? While this issue is one we all want to "put under the rug," it is a serious question that must be resolved now.

The last thing you want is to have your other children fighting and bickering over the ownership of that addition. It must be kept in mind that you have taken perhaps your largest asset -- i.e., your house -- and have in effect given it to your daughter. While this may be your intention, there is an old expression that "when there is a will, there are relatives."

Lawyers are often accused of being too pessimistic. I see my role as attempting to highlight some of the possible "horrible hypotheticals" that can -- and do -- often come up.

We all hope that relations between parent and child will be smooth. However, this is not always the case, and you are smart enough to be worrying about these matters at this early point in time.

Discuss these matters with your attorney and suggest that your daughter and son-in-law retain their own counsel to resolve these matters.

In my opinion, an ounce of preventive law is cheaper than a pound of cure.

For more articles by Benny Kass, please press here .

Copyright 2001 Benny Kass. Posted by Realty Times with permission.

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  About the author, Benny L. Kass

Individual news stories are based upon the opinions of the writer and does not reflect the opinion of Realty Times.