Transferring a home to adult children is not quite as easy as giving them the keys and letting them move in. No matter how you do it, the taxman wants his cut, whether through estate and gift taxes or those for property and income, both federal and state.
The most common way to transfer a property is for the kids to inherit it when the parent dies. Some parents will also make an outright gift of the home to their child, who can incur higher property taxes in states that treat the gift as a sale. It's also possible to finance the child's purchase of the home or sell the property at a discount, known as a bargain sale.
These last two options might seem like a nice solution, as many adult children struggle to buy a home at today's soaring prices, but crunch the numbers with an accountant or financial adviser first. These transactions can get complicated fast, says Lawrence Pon, an enrolled agent and a certified public accountant in Redwood City, Calif.
Here's how they work.
If you sell your home to your child for less than what it's worth, the IRS considers the difference between the fair market value and the sale price a gift. For example, if you sell a $1 million house to your child for $600,000, that $400,000 discount is deemed a gift. You won't owe federal gift tax on the $400,000 unless your total lifetime gifts exceed the federal estate and gift tax exemption of $11.7 million in 2021, but you must still file a federal gift tax return on IRS Form 709.
Sounds simple, right? Not exactly. Now, using the same example, consider the federal income tax consequences. Let's say the parents are married, bought the home years ago and have a $200,000 tax basis in it. When they sell the house at a bargain price to the child, the tax basis gets split proportionately. In this example, 40% of the basis ($80,000) is allocated to the gift and 60% ($120,000) to the sale. To determine the gain or loss from the sale, the sale-allocated tax basis is subtracted from the sale proceeds.
In this example, the parent's $480,000 gain ($600,000 minus $120,000) is nontaxable because of the home sale exclusion. Homeowners who owned and used their principal residence for at least two of the five years before the sale can exclude up to $250,000 of the gain ($500,000 if married) from their income. Pon suggests maximizing the tax benefit of this exclusion.
The child isn't taxed on the gift portion, but unlike inherited property, gifted property doesn't get a stepped-up tax basis. In a bargain sale, the child gets a lower tax basis in the home, in this case $680,000 ($600,000 plus $80,000). If the child were to buy the home at its full $1 million value, the child's tax basis would be $1 million.
You might also want to consider combining your bargain sale with a loan to your child by issuing an installment note for the sale portion. This helps a child who can't otherwise get third-party financing. It also lets parents charge lower interest rates than a lender while generating some monthly income.
At today's low interest rates, parent financing is even more advantageous, says Pon. Make sure the note is written, signed by the parents and child, includes the amounts and dates of monthly payments along with a maturity date, and charges an interest rate that equals or exceeds the IRS's set interest rate for the month in which the loan is made. That rate was recently 1.85% for long-term loans made in November. It's worth going through the legal steps of securing the note with the home so that your child can deduct interest payments made to you on Schedule A of Form 1040. Of course, you'll have to pay tax on the interest income you receive from your child.
To sweeten the deal further, consider making annual gifts by taking advantage of your annual $15,000 per person gift tax exclusion. If you do this, keep the gifts to your child separate from the note payments you receive. As long as you stick to the annual per-person limit, you won't have to file a gift tax return for these gifts.
Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.
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