As part of an estate and gift planning strategy, a taxpayer may consider transferring ownership of a family home to an adult child. Note, however, that the tax implications of such transfers can be significant. When a taxpayer sells a home (or any other asset) for a bargain price to a relative (or any other person), they are actually treated as making a two-pronged transaction. The first prong is considered a sale for an amount equal to the bargain sale price. Their entire basis (cost) in the transferred property is offset against the sale proceeds. The second prong is considered a gift equal to the difference between the fair market value (FMV) of the property and the bargain sale price. The following example illustrates the tax consequences for the seller.
Example: Gwen, an unmarried taxpayer, sells her $600,000 home in 2013 to her unmarried adult son, Frank, for a bargain price of $350,000. Gwen is treated as selling the property to Frank for $350,000 and making a related $250,000 gift ($600,000 FMV – $350,000 sale price).
Gwen’s taxable gain from the sale prong equals the difference between the $350,000 sale price and her entire basis (cost) in the transferred property. For the gift prong, Gwen can use her $14,000 gift tax annual exclusion to reduce the potentially taxable gift amount to $236,000. The $236,000 gift then reduces her $5.25 million (in 2013) federal estate and gift tax exclusion dollar-for-dollar.
Assuming the parent has most or all of the $5.25 million federal estate and gift tax exclusion available to shelter the gift prong of the bargain sale transaction, this type of transaction generally works out quite well for the parent because it removes an appreciating asset from their estate. Also, assuming the parent lives long enough to benefit from any future increases in the federal estate and gift tax exemption, the hit to that exemption will be partially or completely restored.
The sale prong of the bargain sale transaction obviously has income tax implications for the parent. The parent’s capital gain is determined by subtracting his or her entire basis in the home from the sale price. Of course, if the home is the parent’s principal residence, the $250,000/$500,000 federal gain exclusion privilege will usually be available to offset some or all of the gain.
In a bargain sale scenario, the child’s tax basis in the home will generally be the sale price plus the amount of any federal gift tax triggered by the transaction (if any). When the home has appreciated significantly in value (as will often be the case), the child may be stepping into a substantial built-in taxable gain that can cause future problems. This is not a great tax outcome for the child, but complaining about the tax results of an otherwise favorable bargain sale deal seems petty.
On a more positive note, if the child uses the home as a principal residence for at least two years, the federal home-sale gain exclusion privilege will become available. Also, if the child is able to arrange financing for the purchase prong of the transaction, the mortgage interest will generally be deductible as qualified residence interest.
The bargain sale scenario can produce great tax results for the parent. However, as the analysis illustrates, it may produce less-than-great income tax results for the child if the home has appreciated significantly.
Please contact Martini, Iosue & Akpovi by phone at (818) 789-1179 if you have questions or want more information.