10/06/08: Pitfalls of Transferring Property to Relatives
By Benny L. Kass
Q: Is it a good decision to deed our house to one of our children or would it be better to just put these instructions in your will? What is the downside to doing this?
A: There may be serious tax consequences if you transfer your property to your children while you are living. You may not be doing them a favor.
Let's take this example. You bought a house many years ago for $75,000. It is now worth $500,000. You have added $25,000 of improvements. Your basis for tax purposes is $100,000.
You want to be nice to your daughter and decide to give her the house. Since the basis of the person giving a gift (the “giftor”) becomes the tax basis of the recipient of a gift (let's call it the “giftee”), your daughter is now the proud owner of a house with your low tax basis.
You downsize to a smaller property and move out.. Now, your daughter has several choices. She can immediately sell the house, for $500,000. She pays a real estate commission and other closing costs of $30, 000. For tax purposes, since her tax basis is only $100,000, she will have made a profit of $370,000 ($500,000 - 30,000 - 100,000).
If property is held for less than one year before it is sold, the seller cannot claim capital gains treatment. Instead, the profit is taxed as ordinary income. If, for example, your daughter is in a 30 percent tax bracket, she would have to pay as much as $111, 000 in federal income tax. However, since she received a gift from you, the time in which you owned the property is added to her holding period. Assuming that you have owned the property for more than one year, your daughter would then be taxed at 15 percent, which is the current rate for capital gains. Even so, she will still have to pay the IRS $55,500, plus any applicable state and local tax.
She can decide to move in and treat the house as her principal residence. If she owns and lives in the property for two out of the five years before it is sold, she can exclude up to $250,000 of any profit (or up-to-$500,000 if she is married and files a joint tax return). While we all hope that property values will continue to appreciate in the years to come, even if she only gets $500,000 for the house, she may still have to pay some tax on her gain, especially if she is not married. And clearly if she sells the house and makes a profit of over $500,000, she will owe money to the IRS.
If your daughter decides not to move in, she could consider doing a 1031 (Starker) exchange, but once again, there is a big risk. In order to have a successful exchange, the property being exchanged (called the “relinquished” property) must have been held for investment. If she immediately put the property on the market after taking title from you, the IRS can l take the position that the house was not “held” for investment and will reject the exchange transaction.
Finally, your daughter could rent out the house, and become a landlord. Under this scenario, while she could later do a Starker exchange, she will have lost the opportunity to claim the up-to-$500,000 gain exclusion.
Now, let's change the facts. You decide to leave the property to your daughter after you die. Although your estate will have to be probated in a jurisdiction where you were last domiciled, your daughter will be able to take advantage of what is known as the “stepped up basis”. In simple terms, this means that the value of the property on the date of your death becomes the basis of the person who inherits the house.
So if the house is appraised at $500,000 on your death, your daughter can sell it for that price and pay no capital gains tax at all. If she sells it for more than the valuation at death, then she would have to pay some tax on that profit.
In order to take advantage of this stepped up basis, you have to receive the property by “bequest, devise or inheritance”. That's legal language to mean that somehow you inherited the property when the previous owner died.
The answer to your question is not easy. Much depends on what your daughter's plans are. If she wants to live in the house, and you are definitely planning on moving out, then it may be a good idea to give her the house.
But there are other options. Talk with your tax and financial advisors about selling her the house and you take back a mortgage. She will make monthly payments to you. If she cannot afford those payments, you have the right to gift her (completely tax free for both of you) up to $12,000 a year. This gift will help to reduce the value of your estate while at the same time assisting your daughter with the mortgage payments. She can even offset $1000 a month so as to reduce her mortgage obligations to you.
There is one catch to all of this. Unless Congress changes the law, as of January 1, 2010, the stepped up basis rules will no longer be in effect. Instead, Congress has replaced them with a modified carryover basis. This means that if you die after the target date, your daughter's tax basis will be the lower of your adjusted tax basis (which in our example was $100,000) or the fair market value on the date of your death.
The bottom line: should you die after January 1, 2010, your daughter's basis will be the same as yours – namely $100,000. At that point, you might as well consider giving her the house or selling it to her.
There is one additional issue that you should consider. Make sure all of your children understand your rationale for wanting to give your daughter your house. You don't want your other kids angry at you now – or after your death.
For more information, go to the IRS website (www.irs.gov)and click on “Publications” to get Publication 523 entitled “Selling Your Home”.
Kass, Mitek & Kass, PLLC