10 Perfectly Legal Family Tax Shelters

10 Perfectly Legal Family Tax Shelters

Sidney Kess, CPA

If you want to shelter your family's income and wealth from the IRS, there's no need to use complex tax shelter devices that increase audit risk. Consider these simple, perfectly legal family tax shelter strategies...

1. Make interest-free loans. When made to family members in a lower tax bracket, loans shift investment income earned on the loan out of your high tax bracket, reducing family taxes. The borrower avoids paying interest charges to outside lenders that would reduce family wealth.

Limits: Loans of up to $10,000 can be made with no adverse tax consequences. Loans of up to $100,000 can be made at no income tax cost if the borrower has no more than $1,000 of net investment income during the year.

If the borrower's investment income exceeds that amount, the lender will have "imputed" taxable interest income from the loan equal to the lesser of (1) an amount determined by an "imputed interest rate" set by the IRS, or (2) the borrower's actual net investment income. Imputed interest rates are published monthly on the IRS Web site (www.irs.gov). Type "Index of Applicable Federal Rates" into the search box.

Example: You lend $80,000 interest-free to a child who has $1,500 of net investment income. If the IRS imputed interest rate is 4% ($3,200 on $80,000), your taxable imputed interest income is $1,500.

Smart strategy: Make an interest-free loan to a family member who will use it not to earn current investment income, but to build long-term wealth -- such as by buying a home, paying education costs, investing in a new business, or topping off retirement savings accounts.
2. Buy an apartment (or house) for a child who is attending college. When a child goes away to college, you can pay expensive college housing fees and never get anything back.

Instead, consider buying an apartment or a house for the child to live in. You may earn a profit through an appreciating property -- plus tax breaks...

If you don't already have a second home, the house or condo may qualify as one, making mortgage interest on it deductible.

If you rent the house to other students, you can gain tax deductions for a portion of depreciation and other rental expenses (maintenance, insurance, utilities, etc.) -- even if your child lives in it at the same time and pays no rent.

Final gain on the apartment will be tax-favored capital gain. It may even be tax-free if you use the apartment as your residence for two years before selling it (or gift it to the child, who then qualifies for a tax-free sale).
3. Invest in a family member's start-up business. When a child or other family member starts a new business, you may invest in it to both help it get started and cut your tax bill.

Don't make the mistake of lending money to the business. Why...

If the business fails and you are not repaid, the IRS probably will say your loss is not a fully deductible business loss but a deduction-limited personal loss, because you are not in the business of making such loans.

If the business succeeds, interest you receive on the loan will be taxed at top rates.

Better: If the business is a corporation, buy shares in it that qualify as "1244 stock." Under this section of the law, any loss on the sale of the shares will be fully deductible at ordinary rates (up to $50,000 if filing single, $100,000 if filing jointly), while any gain on the sale of the shares will be tax-favored capital gain.

It's easy to qualify a small company's stock as 1244 stock -- just have your tax adviser make sure it meets certain technical requirements.

If the business will have start-up losses, have it organized as a pass-through entity (S corporation, partnership, or limited liability company) and buy an interest in it. You'll be able to deduct your share of the losses on your personal return.

Again, a profitable future sale of your share in the business will bring a capital gain.

Note: If the founder of the new business doesn't want an active partner, you can acquire nonvoting shares or be a limited (passive investor) partner.
4. Get a mortgage interest deduction for a boat or recreational vehicle (RV). A boat or RV can qualify as a residence if it has living facilities (a kitchen, sleeping quarters, and bathroom). Thus, it can qualify as a second home with a purchase loan providing deductible mortgage interest.

5. Shift capital gains. The tax rate on long-term capital gains is only 5% -- and drops to 0% in 2008 through 2010 -- for those in a 15% or lower tax bracket.

The 15% income tax bracket applies to taxable income up to $61,300 on joint returns and $30,650 on single returns in 2006. So, gifts of stocks and other capital gains property to family members below these income levels can reduce gains tax now -- and make future gains tax-free.
6. Place investment real estate in a family limited partnership (FLP). If you own investment real estate, such as an apartment building, consider placing it in an FLP and making gifts of interests in it to the younger generation. Advantages...

Current family income tax is reduced to the extent that income from the property is moved from your top tax bracket into the lower tax brackets of other family members.

Future estate tax is avoided by moving property out of your estate.

Valuation discounts of as much as 40% are common for gifts of FLP interests due to their minority nature and lack of marketability, reducing or eliminating gift tax cost.

You can retain control of a property even while giving most ownership of it away by acting as the general partner of the FLP, while gift recipients become limited partner passive investors.
7. Rent your home out for up to 14 days each year. The rental income you receive is totally tax free -- it doesn't even have to be reported to the IRS.

8. Take advantage of multiple tax-free home sales. Gain on a home's sale is tax free up to $500,000 on a joint return ($250,000, single) if the home has been owned and used as a primary residence for two out of the prior five years. Such sales can occur as often as every two years.

This creates the opportunity for multiple tax-free home sales.

Example: A couple marries with each spouse owning a home, then invests in additional residential real estate. By moving into their homes sequentially over a period of years (to meet the residence requirement), they may claim a series of tax-free gains of up to $500,000 each.
9. Make Roth IRA gifts to children. When a child of any age has earned income, he/she qualifies to contribute to a Roth IRA, and this contribution can be made with funds you provide to the child.

Benefit: The funds move from your taxable account to earning returns in the Roth IRA that may compound totally tax-free for the child's entire life.

A Roth IRA contribution made during teenage years that compounds over decades may provide a tremendous payoff.
10. Avoid the expanded kiddie tax. This now taxes the investment income of children at their parents' tax rate until children reach age 18, up from the previous law's 14. To avoid it, adjust affected children's portfolios to invest in assets that don't produce current income (such as growth stocks and Series EE savings bonds).

Even better: Hire children to work in your business while you deduct their wages. The kiddie tax does not apply to earned income.

Tax Hotline interviewed Sidney Kess, attorney and CPA, 10 Rockefeller Plaza, New York City 10020, coauthor/consulting editor of Financial and Estate Planning ($949/yr.) and coauthor of 1040 Preparation and Planning Guide 2006 (CCH). Over the years, he has taught tax law to more than 700,000 tax professionals.

Please check with your own CPA/Financial Advisor to verify the above.