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You have an adult child who is struggling to buy a home in today’s overheated seller’s market. Meanwhile, you’re ready to unload your current abode. Maybe to downsize or move into a retirement community. Maybe to move to a warmer climate or a lower-tax state. Whatever. You’re financially set and don’t really need the money from selling your home. Hmmm. Here are some thoughts, which range from ultra-generous to practical.
Make outright gift of the home
Say you just give your home to your adult child. If you do that this year, it would reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the FMV of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for this year. The remainder is the amount that would reduce your unified federal exemption.
If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the FMV of the home minus the $16,000 annual exclusion. The remainder is the amount that would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.
If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.
If you expect the home to continue to appreciate (seemingly a good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.
Warning: Do not make an outright gift of the home if you intend to continue living there until the bitter end. In that scenario, expect the IRS to argue that the home’s full date-of-death FMV must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child. Sources: IRC Sec. 2036 and Rev. Rul. 70-155 and 78-409.
Example 1: The current FMV of your home, owned by you and your spouse, is $750,000. You generously decide to make a joint gift of the property to your beloved unmarried daughter.
After subtracting two annual exclusions, the joint gift is valued at $718,000 ($750,000 – $32,000 for two exclusions) for federal gift tax purposes. So, your $12.06 million unified federal exemption is reduced by $359,000 (half of $718,000). Ditto for your spouse’s separate exemption. Neither you nor your spouse owe any federal gift tax, because the gift is sheltered by your unified federal exemption. You and your spouse used up some of your respective exemptions, but you still have a lot left.
As for your daughter, she takes over your presumably low tax basis in the property, which raises the odds that she will owe Uncle Sam when the home is eventually sold for a gain. However, if she lives in the home for at least two years, she will qualify for the $250,000 single-filer federal home sale gain exclusion.
Example 2: Now let’s say that your daughter is married, and you and your spouse decide to make a joint gift of the home to your daughter and her spouse.
After subtracting four annual exclusions, the joint gift is valued at $686,000 ($750,000 – $64,000 for four exclusions) for federal gift tax purposes. So, your $12.06 million unified federal exemption is reduced by $343,000 (half of $686,000). Ditto for your spouse’s separate exemption. Neither you nor your spouse owe any federal gift tax, because the gift is sheltered by your unified federal exemption. You and your spouse used up some of your respective exemptions, but you still have a lot left.
As for your daughter and her spouse, they take over your presumably low tax basis in the property, which raises the odds that they will owe Uncle when the home is eventually sold for a gain. However, if they live in the home for at least two years, they will qualify for the $500,000 joint-filer federal home sale gain exclusion. Nice!
Warning: If you’ve made substantial gifts in earlier years, you might have already used up part of your $12.06 million unified federal gift and estate tax exemption. Ask your tax advisor about that.
Bargain sale
Say you decide to sell your home to your child for less than FMV. For federal tax purposes, you’re considered to have made a gift of the difference between FMV and the bargain sale price. Source: IRC Sec. 2512(b). Tax-wise, this can be OK, as long as you understand what’s in store for all concerned.
Example 3: You’re unmarried and decide to sell your $750,000 residence to your unmarried son for $250,000. In the eyes of the IRS, you’ve made a $484,000 gift ($750,000 FMV minus $250,000 bargain sale price minus $16,000 annual gift tax exclusion). That reduces your $12.06 million unified federal gift and estate tax exemption by $484,000. Except in the unlikely event that you’ve already used up almost of your unified federal exemption by making substantial earlier gifts, you won’t owe any federal gift tax.
What about the federal income tax consequences of the bargain sale for you? Good question. To calculate your taxable gain or loss, subtract the tax basis of the home from the $250,000 sale price. Any loss is nondeductible. If you have a gain, it’s eligible for the $250,000 single-filer federal gain exclusion if you meet all the ground rules (you probably do).
Your son’s tax basis in the home will be only $250,000. So, he will probably trigger a large gain when he sells the property. However, if he lives there at least two years, he will qualify for his own $250,000 federal gain exclusion.
Bottom line: These tax results are acceptable, but not optimal. Please keep reading.
Warning: Do not make a bargain sale of your home if you intend to continue living there until you depart this cruel orb. In that scenario, the IRS can be expected to argue that the home’s full date-of-death FMV remains in your estate for federal estate tax purposes, even if you were paying fair market rent to your child. Source: IRC Sec. 2036 and Rev. Ruls. 70-155 and 78-409.
Full-price sale with financing from you
Not comfortable with giving your home-seeking child a big freebie? I get it. So, let’s look at the alternative of selling the home to your child for current FMV with you taking back a note for a big chunk of the purchase price. When interest rates ae low, such a seller-financed deal will give meaningful help to your child while also delivering the best tax results for both you and your child.
Example 4: You are married and decide to sell your residence for its $750,000 FMV to your married sonny boy and his spouse. The couple can handle a $150,000 down payment. You finance the remaining $600,000 by taking back a note for that amount. Assuming you are feeling charitable, you can charge the lowest interest rate the IRS allows without any weird tax consequences. This is the applicable federal rate or AFR.
AFRs change monthly in response to bond market conditions and are generally well below commercial rates. As this was written, the long-term AFR, for loans of more than nine years, was only 1.90% (assuming monthly compounding). The mid-term AFR, for loans of more than three years but not more than nine years, was only 1.40% (assuming monthly compounding). As this was written, the going rate nationally for a 30-year fixed rate commercial mortgage was around 3.8%, while the rate for a 15-year loan was around 3.2%.
So, you could take back a 30-year note that charges the long-term AFR of only 1.90%. Alternatively, you could take back a note for nine years that charges the mid-term AFR of only 1.40%. Either arrangement would be a very good deal for your sonny boy.
Now for the tax results. Income-tax-wise, you simply sold your home for $750,000. Assuming you qualifies for the $500,000 federal home sale gain exclusion, you will probably owe little or no federal income tax on the deal. Gift-tax-wise, you are in the clear. There is no gift, since you sold the home for FMV. Estate-tax-wise, the sale gets any future appreciation in the value of the home out of your taxable estate. Obviously, these are all good tax outcomes for you.
On your son’s side of the deal, his tax basis in the home is $750,000. If he and his spouse live there for at least two years, they will qualify for the $500,000 joint-filer home sale gain exclusion, which should fully shelter any gain unless the home appreciates very substantially.
If you are so inclined, you can your son out financially after the sale by making annual cash gifts to him under the $16,000 annual gift tax exclusion privilege, or $32,000 if you and your spouse make makes joint gifts to your son (2 x $16,000), or a whopping $64,000 if you and your spouse generously make joint gifts to your son and his spouse ($4 x $16,000). However, don’t make indirect gifts in the form of accepting reduced payments or no payments on the note that’s owed to you. That would invite the IRS to recast the entire arrangement as a bargain sale of your home, with the sub-optimal tax consequences explained in Example 3.
Key Point: You should go through the legal process of securing the note owed to you with the home. Otherwise, your son won’t be able to treat the interest paid to you as deductible qualified residence interest. If the note is not secured by the property, the interest payments will be considered nondeductible personal interest.
The bottom line
There you have it. Some potential solutions to your adult child’s home acquisition challenges in today’s crazy housing market, with the resulting federal tax consequences.
