Scenario: Your adult child wants to buy a home in today’s overheated market. The information below was provided to us from Bradford Tax Institute.

 

Scenario: Your adult child wants to buy a home in today’s overheated market.

 

Needless to say, it’s a struggle against the odds. Meanwhile, you’re ready to check out of your current home.

 

Maybe you want to downsize or move to a warmer climate or a lower-tax or no-tax state. Whatever the reason, you’re financially set and don’t really need the money from selling your home.

 

So, consider the following options to help your home-starved child. We will explain the federal income and estate tax consequences.

 

Option 1: Make an Outright Gift

 

Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid!

 

Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. 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 fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you 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 pretty 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 you depart this planet. In that scenario, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.

 

Example 1. The current fair market value 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 sonny boy.

 

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 respective unified federal exemptions. You and your spouse have used up some of your exemptions, but you still have a lot left.

 

As for your sonny boy, he takes over your presumably low federal income tax basis in the property, which raises the odds that he will owe the feds when he eventually sells the home for a gain.

 

But if he lives in the home for at least two years and remains unmarried, he will qualify for the $250,000 single-filer federal home sale gain exclusion.

 

Example 2. Same as Example 1, but this time let’s say that your sonny boy is married and you approve of the union. So, you and your spouse decide to make a joint gift of the home to your sonny boy and his wife.

 

After you subtract 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 respective unified federal exemptions. You and your spouse have used up some of your exemptions, but you still have a lot left.

 

As for your sonny boy and his wife, they take over your presumably low tax basis in the property, which raises the odds that they will owe the feds when they eventually sell the home for a gain.

 

But 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!

 

Option 2: Arrange a Bargain Sale

 

Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.

 

Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay, as long as you understand what’s in store for all concerned.

 

Example 3. You’re unmarried. You decide to sell your $750,000 residence to your beloved unmarried daughter for $250,000.

 

In the eyes of the IRS, you’ve made a $484,000 gift ($750,000 fair market value – $250,000 bargain sale price – $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 all of your unified federal exemption by making substantial earlier gifts, you won’t owe any federal gift tax. So far, so good.

 

What about the federal income tax consequences of the bargain sale for you? Good question. To calculate your taxable gain or loss, subtract your tax basis in 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 daughter’s tax basis in the home is $250,000 (what she paid). So, she will probably trigger a large gain when she sells the property.

 

But if she lives there for at least two years and remains unmarried, she will qualify for her own $250,000 gain exclusion.

 

Warning. Do not make a bargain sale of your home if you intend to continue living there until you go to a better place. In that scenario, the IRS can be expected to argue that the home’s full date-of-death fair market value remains in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.

 

Option 3: Arrange Full-Price Sale with Seller Financing from You

 

The idea of giving your home-starved child a big free lunch might be unappealing. Very well.

 

Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price.

 

When interest rates are relatively low (they still are, by historical standards), this seller-financed deal can give meaningful financial help to your child while also delivering the best tax results for both you and your child.

 

Example 4. You’re married. You and your spouse decide to sell your residence for its $750,000 fair market value to your married daughter and her hubby. The couple can handle a $150,000 down payment. You finance the remaining $600,000 by taking back a note for that amount.

 

Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).

 

AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In April 2022, the long-term AFR, for loans of more than nine years, is only 2.25 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 1.87 percent (assuming annual compounding)

 

As this was written, the going rate nationally for a 30-year fixed rate commercial mortgage was around 6.1 percent, while the rate for a 15-year loan was around 5.6 percent.

 

So, for a loan made in April 2022, you could take back a 30-year note that charges the long-term AFR of only 2.25 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 1.87 percent. Either arrangement would be a money-saving deal for your daughter.

 

Now for the federal income tax results. In terms of income tax, you simply sold your home for $750,000. Assuming you qualify for the $500,000 federal home sale gain exclusion break, you’ll probably owe little or no federal income tax on the deal.

 

In terms of gift tax, you’re in the clear. There is no gift, since you sold the home for fair market value. In terms of estate tax, 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 daughter’s side of the deal, her tax basis in the home is $750,000. If she and her husband 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 help your daughter even more after the sale by making annual cash gifts of up to $16,000 under the annual gift tax exclusion privilege, or up to $32,000 if you and your spouse make joint gifts to her (2 x $16,000), or up to a whopping $64,000 if you and your spouse make joint gifts to both your daughter and her husband (4 x $16,000).

 

 

Warning. Do not 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 suboptimal tax consequences explained in Example 3.

 

Key point. Go through the legal process of securing the note owed to you with the home. Otherwise, your daughter 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 non-deductible personal interest.

 

Takeaways

 

In this article, you see three options for addressing your home-starved adult child’s housing dilemma

 

• Make an outright gift of your home to the child.

 

• Arrange a bargain sale of your home to the child.

 

• Arrange a full-price sale to your child with seller financing from you.

 

For the federal income and estate tax consequences of each option, review the examples in the article above.

 

Of course, pick the option that makes the most sense for you. We don’t judge!

 

 

 

May 19, 2022 | DWHuff Consulting

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