Published September 02, 2005
Before the days of estate taxes, children simply moved into the family home and took over the master bedroom after their parents died. Unfortunately, it's not that easy anymore.
There are nearly half a dozen ways to give a home to your child. And a couple are tax-free. But in order for the transaction to work properly, you've got to plan ahead. Here is a rundown of your options.
If you plan to live in your home until you die, and your estate is below the $1.5 million estate-tax exemption, this is your best strategy. When you die, your home's tax basis will be stepped up to fair market value. Thus you and your heirs will escape capital gains tax on your home's appreciation. And, because the value of your estate is below the estate tax exemption, your heirs will owe no federal estate tax. They are free to move into the house, or sell it and keep the cash tax-free. If they do move into the house, their tax basis for calculating the gain or loss on subsequent sales will be the home's fair market value at the time of your death.
This is a much better strategy than gifting your house to heirs while you continue living there. Why? 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. The only sure way around this problem is with a qualified personal residence trust, which is explained later in this story.
If you are moving out of your home, you can give the property to your child today. However, you will probably have to dip into your $1 million gift-tax exemption and $1.5 million estate-tax exemption. Here's how it works.
First, offset the amount of the gift by using your $11,000 annual gift-tax exclusion. Remember it's $11,000 per donor. So if you and your spouse each make a gift to both your child and his spouse, you can offset $44,000 of the home's value. Then, as long as the net figure is less than $1 million, you won't owe any current gift tax (unless you made substantial gifts earlier that used up part of your exemption).
There are two drawbacks to this strategy. First, 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 Uncle Sam on a later sale. Second, you've whittled down your estate-tax exemption. (It's reduced dollar for dollar by gifts in excess of the annual exclusion amount.)
On the plus side, you at least get any future appreciation in the home's value out of your taxable estate. This could be a big advantage, given the rapid price appreciation that can occur with home prices in some areas.
Also, your estate tax exemption will gradually be restored (at least partially). It increases to $2 million in 2006, and $3.5 million in 2009. (Your gift-tax exemption will remain fixed at an even $1 million, reduced the net amount of the gift, as calculated above.)
Sale for a Bargain Price
If you sell a home to a perfect stranger for less than fair market value (FMV), you simply made a bad deal. 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 $400,000 and you sell it to your child for $250,000, you just made a gift of $150,000. Of course, you can use your annual gift exclusion to whittle this down by at least $11,000 and maybe up to $44,000. The net amount goes against your federal gift- and estate-tax exemptions. However, that's really OK if the house is expected to go up in price. The sale successfully removes all that future appreciation from your taxable estate.
For income tax purposes, you subtract your tax basis in the home from the $250,000 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 exclusion. (See "Taxes on Selling Your Home.") Your child's tax basis on the home will be only $250,000, however, which increases the likelihood that he will owe income tax on a later sale.
Full-Price Sale With Seller Financing
Instead of making a bargain sale, consider making an installment sale for full market value instead. As you will see, this can still meet your primary objective of transferring the home to your child in a way he or she can afford — probably with better tax consequences.
Here's the deal. You sell the property to your son or daughter for a relatively small downpayment and carry a note for the balance of the purchase price. Let's again say the house is worth $400,000 and your child can afford to pay $40,000 down. So you take back a note for $360,000. Make sure it's a written note. Also, it definitely helps your case if the child has the wherewithal to make the monthly payments.
Speaking of payments. You should charge at least the applicable federal rate (or AFR) on the loan. That rate, which is well below the average commercial mortgage rate, is available monthly in the Internal Revenue Bulletin. Also, as long as you go through the legal process of securing the note with the house, your child can deduct the interest payments to you as qualified mortgage interest. (If you fail to do this, the interest payments are nondeductible.)
You can then help ease your child's financial burden by making gifts under the annual $11,000 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. 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).
Income taxwise, you are treated as making a sale for $400,000. Assuming you qualify for the $250,000/$500,000 exclusion, you will hopefully be able to dodge any federal tax. You will however owe income tax on your interest income from the note. But remember, your child will get an equal mortgage interest deduction, and the whole idea was to help the kid out. Your child's tax basis on the property is now the full $400,000 purchase price, which reduces the chance he or she will owe any income tax when the home is eventually sold again.
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.
A few years after the sale, your child may be able to refinance and pay off the note. If so, your generosity comes to an end with no further tax implications. However, if there's still a balance due when you die, your child will be treated as receiving a bequest if the note is forgiven at that point. Of course, this uses up part of your estate-tax exemption, but you already know you can't take that with you.
What If You Want to Live in Your Home?
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 a seller-financed full market value sale to your child, as explained above, and then rent the property back at the market rate.
In a perfect world, this would remove the home's future appreciation from your taxable estate and you could shelter your entire gain with the $250,000 (for singles) or $500,000 (for married couples) home sale exclusion. The rental payments to your child could, in effect, finance at least part of the cost of buying the home. The payments would be nondeductible to you and taxable income to your child. But he or she could claim rental property depreciation writeoffs, opening up the possibility of noncash deductible losses each year.
In fact, all these nice tax outcomes should be possible — if you sell the home for FMV, pay market-level rent afterwards and use the house as your principal residence. If you sell for less or pay below-market rent, an obscure tax code provision could include the full date-of-death value of the home in your taxable estate. 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.
The bottom line: If you want to transfer ownership to your child but stay put, make sure you make a FMV sale (as opposed to any gift or bargain sale arrangement). Then be sure to pay market-level rent. You can still make $11,000 annual tax-free gifts to help your child out. However, keep these acts of generosity separate from your dealings regarding the sale or rental of the house. In other words, don't forgive payments on your seller-financed note and don't include gifts in your rent checks.
Qualified Personal Residence Trusts
There is one way you can make an IRS-approved gift of your home while still living there. That is with a qualified personal residence trust (or QPRT). Using a QPRT potentially allows you to get the residence out of your taxable estate without moving out — even though you have not made a full FMV sale to your child. 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 federal gift- and estate-tax exemptions.) 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.
Of course, if you have a poor relationship with your kids, you might find yourself out on the street. And 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.