Tax Efficient Options (from a US perspective) for Giving Your Home to Adult Kids
Probate avoidance and asset protection mean that, for some families, selling or gifting are options worth considering.
Gift Tax Rules
It may be worth quickly reviewing my previous posts on how this works -
Option 1 - Do Nothing and Allow the Home to Form Part of the Estate
If you plan to live in your home until you die, and your estate is below the unified federal estate gift and estate tax exemption amount ($11.4 million for 2019), this is a good strategy.
1. When you die, your home’s tax basis will be stepped up to fair market value as of the date of death.
2. Heirs will escape capital-gains tax on all the appreciation that occurs up to that date.
3. If the value of your estate is below the estate tax exemption, your heirs will owe no federal estate tax.
The downside is
1. It has implications for your health care cost management strategy which tend to be high in the later stages of life
2. Even if you pay a market-rate rent to your child, the IRS might argue the home’s full date-of-death value still belongs in your taxable estate.
So given the downsides, let's explore other options.
Option 2 - Outright gift
Move out of your home and give the property to your child today.
Here’s how it works.
1. Offset the amount of the gift by using your $15,000 annual gift-tax exclusion. Remember it is $15,000 per donor per donee (gift recipient). So if you and your spouse make a joint gift to both your child and his spouse, you can offset $60,000 of the home’s value (4 x $15,000) for gift tax purposes.
2. Then, as long as the net figure is less than $11.4 million or $22.8 million for a married couple for 2019, you won’t owe any current gift tax (unless you made very substantial gifts earlier that used up part of your exemption).
On the plus side, you at least get any future appreciation in the home’s value out of your taxable estate. There are two drawbacks to this strategy.
1. Your child’s tax basis on the home will be your presumably low cost for the property, which increases the odds he or she will owe (higher than otherwise) capital-gains tax on a later sale.
2. Second, you’ve whittled down your unified federal gift and estate tax exemption (the exemption is reduced dollar for dollar by gifts in excess of the $15,000 annual exclusion amount).
Option 3 - Sale for a bargain price
If you sell a home to a perfect stranger for less than fair market value (FMV), the IRS doesn’t care. When you sell to a relative, however, it’s a different story. You will be treated as making a gift equal to the difference between FMV and the sale price.
For example, if your house is worth $700,000 and you sell it to your child for $350,000, you just made a gift of $350,000. Of course, you can use your $15,000 annual gift exclusion to whittle this down. The net amount of the gift then goes against your unified federal gift and estate tax exemption ($11.4 million for 2019). However, that’s OK if the property is expected to appreciate, because the sale successfully removes all future appreciation from your taxable estate.
For income tax purposes, you subtract your tax basis in the home from the $350,000 sale price to calculate your gain or loss. Any loss is nondeductible. If you have a gain, it’s probably eligible for the $250,000 (for singles) or $500,000 (for married couples) home sale gain exclusion. However, your child’s tax basis in the home will be only $350,000, which increases the likelihood that he will owe capital-gains tax on a later sale.
Option 4 - Full-price sale with seller financing
Instead of Option 3, consider an installment sale for full market value instead. This can still meet your primary objective of transferring the home to your child in a way he or she can afford — in a tax efficient manner.
1. You sell the property to your son or daughter for a relatively small down payment and carry a note for the balance of the purchase price.
2. Make sure it’s a written note.
3. The child should have the wherewithal to make the monthly payments.
4. You should charge at least the applicable federal rate (or AFR) on the loan. That rate, which changes monthly and is almost always well below the average commercial mortgage rate, is available in monthly Internal Revenue Bulletins. You can find them on the website at www.irs.gov.
5. Make sure to go through the legal process of securing the note with the house. That way, your child can deduct the interest payments made to you as qualified mortgage interest. If you fail to take this step, your child won’t be able to deduct the interest payments.
6. If you wish, you can then ease your child’s financial burden by making gifts under the annual $15,000 gift-tax exclusion rule. Just make sure your child actually makes all the payments on the note. Then write checks for any gifts you decide to make. That keeps the sale, the note and the gifts separate.
7. If you simply forgive some of the payments, the IRS may recast the entire arrangement as a bargain sale (with the less-desirable tax consequences explained earlier).
8. Income-tax-wise, you are treated as making a sale but you should qualify for the $250,000/$500,000 exclusion to legally avoid any federal capital-gains tax. You will however owe income tax on your interest income from the note.
9. Your child’s tax basis on the property is now the full purchase price, which reduces future cap gains on sale.
10. As far as the gift tax is concerned, you are in the clear. Estate-tax-wise, the sale removes from your taxable estate any future appreciation in the value of the home.
11. A few years after the sale, your child may be able to refinance and pay off the note.
Option 5 - What if you want to live in your home?
Unfortunately, the IRS gets curious when you transfer your home to a relative and then continue to live there.
So Option 4 as explained above is the best bet. Then rent the property back at the market rate.
1. The rental payments to your child could, in effect, finance at least part of the cost of buying the home.
2. The payments would be nondeductible to you and taxable income to your child.
3. If you sell for less or pay below-market rent, this may have adverse tax consequences. Why? Because you are considered to still own the home since you never completely gave up “possession and enjoyment” of the property. Also, paying below-market rent will preclude any deductible rental losses for your child.
Option 6 - Qualified personal residence trusts (QPRT)
There is one way you can make an IRS-approved gift of your home while still living there. But there are heavy risks involved.
Here’s how a QPRT works. Say a retired doctor in Florida wants to give his $1 million beachfront home to his two daughters. This strategy would require the doctor to put his home into an irrevocable trust for several years, while he continues to live in it. Through a complex IRS calculation based on interest rates, the length of the trust and his age, the IRS values his right to live in the house at, say, $600,000.
For the purposes of his taxable estate, that knocks the value of his house down to just $400,000 — regardless of how much the house appreciates in the meantime. (That $400,000, though, comes out of the doctor’s unified federal gift and estate tax exemption.) When the trust is up after the stipulated number of years, if he chooses to continue living there, he can pay his daughters rent, further reducing the size of his taxable estate.
There is a tax catch to this kind of trust: You have to outlive it. If you die before the term of the trust expires, the full date-of-death value of the house is included in your taxable estate and your heirs receive no estate tax benefit.