How to Give Your Home to Your Children Tax-Free
- For each option, think about these taxes
- Parents’ capital gains tax
- How capital gains works
- $250k exemption
- Free step-up in basis
- Child’s capital gains tax
- Child’s income tax (deductibility of housing costs)
- Parents’ gift tax and estate tax
- Parents’ capital gains tax
- Stay put
- Outright gift
- Sale for a bargain price
- Full-price sale with seller financing
- What if you want to live in your home?
1. Parents’ capital gains tax
a. How capital gains works
Anthony: So, this is a little heavier and more detailed than what we usually talk about, but yeah. Let’s see if our listeners find this useful. Let us know, email, social media posts, whatever. Let us know what you think. Okay, so before we jump into the article like we usually do, I’m going to give a little kind of primer or background on the tax issues, the five tax elements you need to think about, sort of like a checklist, as you evaluate, what are your options for transferring property from a parent to a child. The first element is capital gains tax from the parents’ perspective. Just real quick, this is real high-level … If any of this trips you up, talk to your accountant or attorney, please, but at a real high-level, capital gains tax is the tax you pay on your profit from something, right? Sometimes it can be stocks, but in this context, we’re talking about home. So just a real simple example, and I’m gonna use big numbers ’cause I like big round numbers. If you bought a home 20 years ago for $100,000 and it’s now worth $1.1 million, what’s your profit, Janice?
Janice: Oh, first of all, that’s a really great gain.
Anthony: Nice, right?
Janice: I’d like to know how that worked out, but yeah. We’re looking at like, what? $900,000?
Anthony: No, no. I said $1.1.
Janice: Oh, $100,000 then. Let’s-
Anthony: No, no, no.
Janice: Oh, for crying out loud.
Janice: First of all, let’s start over with some coffee, and then we’re gonna go with million.
Anthony: Yeah, so you’ll gain, meaning the amount you made over your buy-in, otherwise known as your basis. That $100,000, your purchase price, it’s called your basis. It’s just a tax term. So, your gain is a million dollars, and then depending on the state or how the capital gains tax rates are at the time, it’s about 20%. So, you’re gonna owe $200,000, 20% of a million dollars, when you sell at $1.1 million. Okay, so that’s just generally how capital gains works. I can give more examples. You buy at 100. You sell at 500, your gain is 400, and 20% of $400,000 is $80,000. I mean, you could just keep doing examples, but let’s move on.
b. $250k exemption
Anthony: Okay, capital gains rule number two that you need to be aware of is the $250,000 capital gains exemption. In a nutshell, if this is your primary residence, there’s some special rules to that. There’s I think a two out of five year rule, but anyway, generally, if it’s a primary residence, when you sell, the first $250,000 of gain is exempt from capital gains. It’s a nice little gimme from the IRS. If you’re a married couple, it’s 500K. Okay, so this is great. If you bought a house at 100,000 and you sell at 500,000, meaning your gain is 400,000, and you’re a married couple, you don’t owe anything. Isn’t that nice?
Janice: That is very nice.
Anthony: What otherwise would’ve been an $80,000 tax bill for selling your home, you pay nothing. That’s something you need to sort of factor in as we evaluate these options.
c. Free step-up in basis
Anthony: Last sort of capital gains tax rule that you need to be aware of is called free step up in basis. You ever heard of this one, Janice? I’m wondering how many people have heard of this.
Janice: I have not, actually, at all.
Anthony: Okay. Let’s say Grandma bought a house for, again, $100,000 decades ago, and it’s now … I’m gonna use the $500,000 example ’cause you seemed blown away by the 1.1.
Janice: Yeah. I was having a little bit of trouble with that. We have such a significant [inaudible 00:04:17]. I couldn’t even do the tiny math.
Anthony: So, Grandma bought it for 100,000, and it’s now worth 500,000, a $400,000 gain. Yeah, she gets the 250 exemption, so she still has a 150 gain, right? You with me so far?
Janice: I’m with you.
Anthony: What is that? A $30,000 tax. If she passes away and gives it to her only son or whatever, only son’s basis, meaning when you’re calculating the gain, jumps up from 100,000 to the value at the time of Grandma’s death. So now, his purchase price, quote on quote, is not $100,000, but it’s the $500,000 the house was worth when Grandma passed. If he sells it immediately for $500,000, no gain. Right?
Janice: Got it.
Anthony: If he continues to live in Grandma’s house, he moves in and sells it later when it’s worth a million decades later, it’s not the spread between 100,000 and a million. It’s the spread between 500,000 and a million.
Janice: At the date of death.
Anthony: Right. That’s called step up in basis.
Anthony: It’s, again, another freebee the IRS gives you for upon passing.
Janice: Very interesting. You know what I heard from most of everything you said is, you need a professional when dealing with this because there are a lot of intricacies in some of these things that you normally wouldn’t know.
Anthony: And thank you for keeping me in check because as an attorney and someone who is experienced with this, I sometimes feel like some of this stuff is a gimme, and you really helped me realize, or help me remember, that this can be a mind pretzel for a lot of people.
Janice: Well, it is. Like you said, there’s three different ways. I’ve heard of one, but not really how [inaudible 00:05:56]. I mean, it is interesting that, like you said, the gain from once you’ve passed and when it’s due now. I mean, really, professional is the way to go. Of course, we could talk about these numbers, anyway, but …
2. Child’s capital gains tax
Anthony: Okay, so I’ve covered the basics of capital gains tax, how it works. You take your purchase price, subtract your … Excuse me. You take your sale price, subtract your purchase price, and that’s your gain, and then you’ll apply the tax rate to that, and then if it’s been your primary residence, then one person can knock out 250,000 of gain, and a married couple can knock out $500,000 of gain, meaning is exempt from tax, and lastly, you get a free step up in basis. When you pass away, your heirs get the valuation at the time of death, not what you bought it for. Okay? I think that’s as much as I can do in this, again, really sort of brief format. Let’s move on.
Janice: That helps to explain, I think, this article a little bit better when we get into it.
Anthony: Nice. You need to think about all those things I just talked about from the parents’ capital gains tax point of view, but you also need to apply that whole analysis to the kids’ capital gains tax point of view. I’ll give some illustrations as we go through the article’s examples.
3. Child’s income tax (deductibility of housing costs)
Anthony: You also need to think about the kids’ income tax. What I mean by that is, there are some scenarios that we’ll talk about where it kind of matters who gets the deductions, who can get the mortgage or real estate tax, or in the case of a condo, co-op maintenance fees. You want to optimize who would get the most benefit from being able to deduct that. Does that make sense?
Janice: Yes, it does, absolutely. You’re taking the whole picture into play.
Anthony: Right. I mean, that’s [crosstalk 00:07:30] not really gonna move the needle as much as those big numbers we talked about before with the capital gains, but it can be something that’s worth considering.
4. Parents’ gift tax and estate tax
Anthony: There’s always gonna be gift and estate tax issues. Gift tax is there is a tax when you give, just straight up give, property from one person to another. Estate tax is a tax on your wealth upon your passing, but because both of these taxes really apply to individuals who die with over 5 million in net worth, or as a married couple, over 10 million in net worth. I don’t really want to cover that here because you need to talk to a pro. You can’t be getting that from a podcast.
Janice: Oh, definitely, definitely, definitely. I think what you’re saying there, if it is that significant of a monetary value of 5 million, 10 million, get a professional.
Anthony: Right on. Just know that the takeaway is, yes, gift and estate tax issues totally apply to a lot of these situations if you’re above those thresholds, 5 or 10 million, single or married, but we’re not gonna cover that here. All of our examples are all going to assume that those are just non-issues, just for the sake of the format we’re talking in. Yeah?
A. Stay put
Janice: If you plan to live in the home until you pass, and your estate is below that five million that you had mentioned earlier, then it’s a good strategy. He said it’s the best strategy. So, what does that mean? What do you think?
Anthony: I do agree that this is the best strategy if it fits the life strategy that, you know, everyone’s needs for the family involved. If the parents are going to stay there, anyway, or if the parent staying there somehow can make sense, getting the free step up in basis, meaning, remember, that’s the one where the heirs will ultimately get the cost of … How do I say this cleanly? Their cost purchase price will translate into the value at the parent’s date of death. That is often the biggest savings you can get, so you really want to keep that, right?
Anthony: For that reason, alone, almost, having the parent-
Janice: That’s worth it.
Anthony: Yes. That’s the biggest mover of all these options, and that’s why staying put of it really makes the most sense in most cases.
B. Outright gift
Janice: Interesting. The second option is an outright gift. If you’re moving out of your home and give the property to your child today, however, you’re probably, he says, have to dip into your gift estate tax exemption. Could you explain a little more how that would work as an outright gift?
Anthony: Okay. I’m gonna skip the part about dipping into your gift and estate tax exemption. Again, we’re assuming these folks, our folks, this doesn’t apply. If you think you’re in the 5 to 10 million range, call me or another attorney, and we’ll talk about your specific situation.
Anthony: Outright gift, okay, so mom gives house to adult son because son wants to live there and mom is moving to the condo in Florida, whatever, I don’t know. Here’s why that can be a bad idea, or not as an optimal idea. Let’s put it that way. If mom bought the house, again, at $100,000 and it’s now worth $500,000, if she gifts it to son, number one, son’s basis stays at $100,000, not the $500,000 or the current market value. So, son is looking at a pretty big capital gains hit later, right?
Anthony: If and when the son eventually sells. Also, the mom is sort of giving up her 250K exemption. Remember we talked about the individual and a couple get-
Anthony: Either $200 or $500,000 exemption. So, she just kind of made no use of that, so you’re kind of losing a huge tax break, right?
Janice: That’s huge, yeah.
Anthony: That being said, if this makes sense from a lifestyle perspective, meaning it’s what the family needs, you want to make decisions that make sense, not just from a tax perspective, right? It can make sense. If the son gets, using the same example, the $500,000 house from mom and dad, and gets that old $100,000 basis, but son is married, so they get the $500,000 exemption, that means the house can increase in value to up to 600K before they pay any tax at all, so it’s kind of like it might not matter. Does that make sense?
Janice: Yes, I got it, definitely.
Anthony: So, just kind of do the math, basically.
Janice: Yeah. It’s in math, and it sounds like a planning thing. So if you’re getting ready to do this, you should talk to somebody, but maybe not when you’re getting ready, but even beforehand. If you know that the house will go to somebody, it sounds like you should do a little bit of planning originally, maybe not as last minute. Does that make sense? This is kind of a process. You want to make sure you’re making the right decision now and in the future.
Anthony: I mean, do the best you can.
Anthony: Talk to somebody who knows what they’re talking about and can run through the numbers for you, but if the market tanks or spikes upwards, I mean, it can throw a monkey wrench at any plan. Just do your best.
C. Sale for a bargain price
Janice: Oh, absolutely, absolutely. Another option is sale for a bargain price. If you sell a home to a perfect stranger for less than the fair market value, you’ve simply made a bad deal. The IRS doesn’t necessarily care, but when you sell it to a relative, however, it’s a different story. They talk about it’ll be treated as making a gift equal to the difference between the fair market value and the sale price. Can you elaborate on that?
Anthony: Sure. Again, we’re gonna ignore gift tax for the time being, but the author is absolutely right. You can’t sell a Mercedes to your son for $1, right, or not a Mercedes, a house to your son for $1 ’cause that’s effectively a gift, right? I mean …
Janice: Right, right.
Anthony: It’s not even close to [inaudible 00:13:44], and things get squishier when it’s close to fair market value, like if the house is worth 500 and you sell it for 400. Then you get into these little arguments with the IRS, right? But-
Janice: Nobody likes to argue with the IRS.
Anthony: Yeah, nobody wants to have any confrontation with the IRS.
Janice: [crosstalk 00:13:57]. I’d like to do it, but …
Anthony: So, the bottom line of why this strategy makes sense in some scenarios is what I talked about before. The parents should not just totally erase their exemption, their 250K exemption. If they do it … And also, you don’t want to totally give up your step up in basis. So, instead of giving the $500,000 house to son, losing, you know, completely just obliterating your 250K exemption and the son getting a $100,000 cost basis, his purchase price, if you sell to the son for 350, right?
Anthony: The mom doesn’t pay any tax because she’s still covered under her 250K exemption over the 100K she paid. Now the son gets a 350K basis, not a 100K, right? And it’s kind of in the middle. It’s almost like a gift, ’cause there will be gift tax implications ’cause you sold it 150K below market value, but you’ve captured some of mom’s free 250K exemption, and you’re not sticking the son with 100K low basis. He gets a slightly higher basis, well, not slightly, three times the higher basis.
Anthony: Again, it’s just kind of the math of the situation.
Janice: Interesting. [crosstalk 00:15:15]-
Anthony: Janice, I need a reality check. Am I making sense? Is this gonna be … Yeah.
Janice: What I’m thinking hear is … I mean, this is not my forte, but it’s really interesting to see that what you do and how you sell could have all of these ramifications, whether it’s positive or negative. What I am hearing is that it’s just so important to talk to somebody and get the correct information before you make the move.
Anthony: Right. So even if you’re not getting everything I’m saying, does it at least sound like I know what I’m talking about?
Janice: Oh, absolutely, absolutely. I’m just going, wow, I couldn’t even do the math on 100,000 to one million [inaudible 00:15:51].
Anthony: That’s right.
D. Full-price sale with seller financing
Janice: So instead of making a bargain sale, which we just talked about, consider making an installment sale for the full market value, instead, so meeting that objective, transferring the home, but maybe with better tax consequences. Would you explain that one in detail?
Anthony: Yeah, no problem. That’s, again, going back to our scenario. Mom bought a house for 100K, and it’s current market value is 500. Instead of giving it to your son or selling it to him at a discounted price, she just straight up sells it to him for 500K, a true fair market price, I mean, to the extent their is such a thing as a true fair market price, right?
Janice: Right, but you’re getting close enough, right.
Anthony: But, she doesn’t actually want to collect 500K from her son, but the reason they do this is to, number one, give the son the full 500K basis, right, meaning when he sells later, his cost basis, his purchase price will be pegged at 500, not some lower amount as low as $100,000.
Anthony: But in order to do that and not collect straight up 500K from the son on the spot, she basically becomes the bank, right? She becomes the mortgager, and the son has every payment obligation to her, you know, bank of mom, whatever you want to call it.
Janice: The bank of mom. I think we all have known that bank.
Anthony: Yeah, yeah, [crosstalk 00:17:30].
Janice: Whether it was a couple dollars there or … Right.
Anthony: So then what you do from there kind of depends on the situation. You can have the son or the mom forgive some of the loan payments. It’ll be set up like a real mortgage where you have monthly payments and all that, and the mom can forgive them, and it’ll be sort of like annual gifts. Again, we don’t want to jump too deep into gift tax, but each payment she forgives can be applied to her gift tax situation, right? Or, she can collect part of it so that the son can have a deductibility on his income tax returns, and maybe he has the flexibility to maybe send some cash his mom’s way and help her have a lovely retirement, so that make sense from both sides and reduce gift tax implications.
Anthony: It kind of really depends, but there’s a couple different ways to finagle that.
Janice: That’s actually very interesting. The bank of mom, though, I liked that one.
Anthony: I know, right?
Janice: And it does say to have it definitely inviting, not just an agreement between the two as you’re sitting having your coffee, but it does say to have it in writing. Would you agree with that one?
Anthony: Oh, absolutely, great point by Bill Bischoff. You want this to be … When I said bank of mom, I kind of meant, like, you need to record a mortgage with the Register of Deeds or New York City ACRIS. You need to just, yeah, exactly, document everything. You should treat it seriously because, otherwise, if it’s-
Janice: Like a real mortgage.
Anthony: Yeah. If it gets really fudgy, the IRS is not gonna like that.
Janice: Again, we do not want to have to have any confrontation with the IRS at all. That’s what this is about, is to try to make it as smooth as possible.
E. What if you want to live in your home?
Janice: “Unfortunately, the IRS gets cranky when you transfer your home to a relative and then continue to live there, so tread carefully if this is your intention.” One strategy is to make that seller financed a full market value sale to the child and then rent the property.
Anthony: Mm-hmm (affirmative).
Janice: What would you suggest if they wanted to live there, but sell it while they’re living there? They’d still live there.
Anthony: This point, I’m gonna punt because it’s quite complicated.
Anthony: And you should really speak to an advisor. They talk about QPRTs, which are qualified personal residence trusts. It’s just not appropriate to discuss it here. I mean, it would be its own topic. Let’s put it that way.
Janice: So you know it’s complicated when he says, “No, I’m not even gonna touch it.” [crosstalk 00:19:54].
Anthony: Yeah, I mean, not here, at least. Plus, we’re kind of running up against their time limit.
Janice: Absolutely, so that’s that qualified personal residence trust, is what he speaks about last is it’s one way. It’s an IRS approved gift of your home while still living there. So like you said, that’s a pretty complicated way to do this, but you should speak to a professional and get the correct information on how to do it.
Original post by Bill Bischoff