For many parents, anxiety about paying for their children’s college educations sets in at about the same time the “+” sign on the pregnancy test comes into view. The cost of college has outpaced the rate of inflation for years, and many experts expect that trend to continue. And while a higher percentage of students today do receive various forms of financial aid, when household income exceeds $80,000, the odds of receiving need-based aid begin to fall dramatically.
There is a big difference, of course, between not qualifying for aid and being comfortably able to write a check for $26,000 (the average cost of a year at a private college in 2005). But there are a number of strategies that families can employ so that Mom and Dad don’t have to hitchhike to Parents Weekend.
Rick Jarvis, for example, plans to foot the bill with other people’s money. Jarvis does have an advantage: his strategy is built around real estate, and he is a realtor. But his approach could be modeled by almost anyone. Jarvis owns a modest portfolio of residential and commercial buildings in and around Glen Allen, Virginia, and has designated two single-family homes as “College Education I and College Education II.” He says the two homes, which are currently worth about $175,000 and $250,000, respectively, are a better place to stash cash for college for his grade-school-aged kids than, say, government-sponsored 529 plans, mutual funds, or savings bonds.
Four years ago, he used 100 percent bank debt to purchase two rental properties, with the assumption that the value of the homes would increase in step with the cost of a college education. Jarvis says that by the time his children, ages eight and six, are ready for college, the debt will be minimal (thanks to the steady stream of rental income) and he will either refinance to free up cash or use what is known as a tax-deferred Internal Revenue Code Section 1031 exchange.
The 1031 exchange allows property owners to enter into a tax-deferred exchange of like kind and reinvest the proceeds without incurring current income tax such as the capital-gains tax. For example, a parent making a 1031 exchange could use the deferred gains reaped as a big down payment on a larger rental property, which would boost cash flow via higher rental income just in time to pay for college.
Another option is to use the 1031 exchange to buy a house or condo for your college student, thus avoiding room and board costs and creating some flexibility. For example, by renting the property to their child, parents can write off ordinary expenses associated with a rental property, such as visiting the site, repairs, and management fees. To make sure the business deductions are legitimate, the student would have to pay rent at fair-market prices. But the Internal Revenue Service allows a parent or any other individual to dole out a tax-free gift of up to $12,000 ($24,000 for couples) annually. Such a gift to a student could then be used to pay the landlord.