Helping Your Kids Buy a House Using Your Investment Real Estate

For many families, one of the biggest financial hurdles today is helping their adult children purchase a home in an increasingly expensive housing market.

In San Diego, homeownership has become extremely difficult for the younger generation due to high housing prices caused by limited supply and high demand. As one might imagine, the supply constraint is largely due to San Diego’s geography: the Pacific Ocean limits home construction to the west, Mexico borders the region to the south, mountains and desert terrain restrict growth to the east, and Camp Pendleton constrains development to the north.

Since San Diego’s geography won’t be changing anytime soon, many investment property owners look to their own investment real estate for solutions to help their kids out.

For some families, that means refinancing an investment property to access cash. For others, it means selling property, taking the tax hit, and using the sale proceeds to assist children directly (either through help with a downpayment or private loan). In certain situations, a 1031 exchange into a replacement property and leased to family members may also merit consideration.

Let’s take a closer look at these options.

Option 1: Cash-Out Refinance

One of the simplest strategies is a cash-out refinance on an existing investment property.

If a property has appreciated significantly and carries little or no debt, refinancing allows a parent to access equity without selling the property. Those proceeds can then be gifted or loaned to children for a home purchase.

The advantage here is that the money borrowed in a cash-out refinance is not taxable. Parents also retain ownership of the investment property and continue reaping the rewards of appreciation and rental income.

However, refinancing will introduce a new debt service obligation. Property owners must evaluate how the new principal and interest payments will alter the property’s cash flow.

Option 2: Traditional Sale

Some owners instead choose to sell an investment property outright and use the sale proceeds to help their kids purchase a home.

The primary drawback to an outright sale is, of course, capital gains taxation. For owners with a low tax basis, capital gains tax will become the single largest issue requiring evaluation when planning a sale.

Option 3: 1031 Exchange Strategies

Standard 1031 Exchange - For owners who want to defer capital gains, while helping children with housing, a 1031 exchange may provide additional options.

Parents may exchange out of one investment property (the “relinquished property”) and acquire another property (the “replacement property”) that the children then lease. Some property owners are surprised to learn that selling a multifamily investment property or commercial building and acquiring a single-family rental home qualifies as a like-kind exchange.

Reverse 1031 exchange - While more complex and expensive, a reverse 1031 exchange allows a replacement property to be acquired before the relinquished property is sold. This can be useful when a desirable replacement property becomes available before the parents are ready or able to sell the relinquished property. The crux of a reverse 1031 exchange is committing to the purchase of a replacement property before knowing exactly when, or for how much, the relinquished property will sell.

Partial 1031 Exchange - Some owners prefer a hybrid approach through a partial 1031 exchange by deferring most, but not all, of their capital gains.

Through a Partial 1031 Exchange, a seller uses most, but not all, of the net proceeds from the sale of the relinquished property to purchase the replacement property. That retained cash, referred to as “boot,” is taxable, but is also immediately available cash that can be used to help children. An example could look like this: Mary sells an investment property and nets $2,000,000 in sale proceeds. She then uses $1,800,000 of the $2,000,000 to buy a replacement property and keeps $200,000 to help with a house downpayment for her daughter. The $200,000 is then deemed “boot” and is taxable in the year of the sale.

Structuring a Subsequent Purchase

For options 1 and 2, or a partial 1031 exchange, parents may utilize cash to:

1. Gift funds toward a down payment to help reduce principal and interest payments or avoid private mortgage insurance

2. Lend money to children, with the parents holding a secured note

When parents act as the bank and carry a mortgage note for a portion of the purchase price, loan terms are often structured more favorably than conventional financing. A mortgage loan from a parent can allow a child to present an offer on a house that more closely resembles a cash offer to a seller, which creates negotiating leverage and frequently leads to a discounted purchase price.

A 1031 exchange can also serve as a family wealth-planning tool. In either a traditional or reverse exchange, parents may acquire a replacement property and lease it to their adult children, at the fair market rental rate. At a later date, the property may be transferred to the children through an outright sale, allowing the parents to recognize their deferred capital gain in a tax year that may be more advantageous. Alternatively, a subsequent sale may be structured as an installment sale, allowing the parents to spread gain recognition over multiple years and potentially manage their tax liability more efficiently.

Parents should be aware that leasing a 1031 replacement property to adult children could result in higher IRS scrutiny, so consult a qualified tax advisor about your situation.

Balancing Family Goals and Investment Goals

Some families prioritize maximizing long-term tax efficiency by exchanging and leasing back to their kids, who have an eye towards ownership one day. Others prioritize simplicity and immediate cash. The right solution depends on the owner’s long-term goals.

As with any major financial decision, owners should consult with qualified tax advisors and real estate professionals before implementing any strategy.

For many long-time property owners, investment real estate becomes more than just an income-producing asset. When properly utilized, it becomes a tool to help the next generation establish financial stability through homeownership.

Author: Eric Lowe, Company: Pierson Post Eric Lowe is a real estate broker and founder of Pierson Post, a commercial real estate brokerage based in Bonita, CA. He began his career as an attorney handling complex real estate transactions across Southern California. As a broker, Eric helps owners decide when and how to sell, designs targeted marketing strategies, and guides 1031 exchanges. He blends institutional deal expertise with boutique client service. Call Eric at 619-813-7583 or email him at elowe@piersonpost.com.