Q&A: Tax-Advantaged Methods for Gifting Home to Children

Question: My health is not good and I'm selling my business. Both my wife (now deceased) and I had always wanted to give our home to our two children. Should I do this now or through my will?

Answer: You should ask your lawyer and accountant about this, but there are several options and considerations to discuss with them. Here are four options to consider:

Option l. Transfer the home through your will.

If you give your home to your two children through your will, the cost basis will be stepped up to fair market value at the time of your death. This approach thereby saves taxes.

Example of tax savings: If your home cost $150,000 with improvements and the fair market value is now $250,000, there's a potential taxable gain of $100,000. But by transferring the home through your will, your children's tax (cost) basis will be set at $250,000 not your $150,000 so they save some big dollars by avoiding the capital gains tax when they sell the home.

Note: Your estate can avoid federal estate taxes on the bequest by using part of your lifetime gift and estate tax exemption to transfer the home and any other assets you wish to leave to your children.

Option 2. Gift the home now and use part of your lifetime gift exemption.

This option is less tax advantageous but has some unique advantages. Use part of your lifetime gift tax exemption while you're alive and give the home to your children today. You pay no federal gift taxes on the gift because it is within the limit (currently $1 million) but your children inherit your tax basis, i.e., $150,000. Thus, this approach has a built-in capital gain of $100,000 and the associated taxes (currently 15% federal) when the property is eventually sold by your children. It also involves working out a fair rental arrangement with your children if you want to live in the home until your death. Although this further complicates the transaction, your lawyer can help with the details.

Option 3. Sell the home now using your homestead exemption. Gift cash to children.

If you do not intend to continue living in your home, you can sell it and use your homestead exemption to completely avoid tax on the sale. You pocket $250,000 from the sale, less closing costs. Use the cash to live on or give it to your children through your will or annual gifts.

Important: You can give $11,000 annually to each of your children without filing a gift tax return. Ditto to in-laws. But if you gift $11,000.01, a gift tax return must be filed.

Note: This approach, as well as #4 below, assumes neither child wants to live in the home.

Option 4. Sell home to the children on terms and incrementally forgive the obligation.

This approach is also complex but should be discussed with your tax attorney. You sell your $250,000 home to your two children in exchange for an interest-bearing note, payable annually over, say, 20 years. You then "forgive" some annual payments by using your $11,000 annual gift allowance for each child. The payments due to you are in effect "forgiven" by an annual gift from you in the amount of the payment. This approach accomplishes the following:

·       You take advantage of your home exemption to avoid capital gains tax.

·       Your children get the step-up in value, i.e., their cost basis is $250,000.

·       You don't use any of your federal estate tax exemption and thereby leave all of it to shelter other assets in your estate from tax at the time of transfer.

Caution: If you forgive all of the payments due under this method, the IRS could contend that you initially never intended to collect on them and thus you really made a gift of the home. But such an IRS attack might be avoided by applying your $1 million lifetime exemption to cover the forgiven notes. To minimize the chances of the IRS questioning this approach, lawyers recommend not forgiving all of the notes, particularly in the early years.

One tax advantage of gifting or selling the home today is that it keeps any future appreciation in the value of the home out of your taxable estate.

Good tax and legal advice is needed to properly implement these options. Invest the time and money to make the right decision.

Finally, discuss your home transfer plans with your children. You might find that one of them is interested in moving into the home with his or her family and the other child has no interest at all in ever living there. In that case, you might want to transfer the home to the one child only and earmark other assets for the other child in an amount comparable to the value of the home. Advantage to this approach: You avoid any problems between your children as to whether the house should be kept or sold and you assure that it is kept in the family by the child who plans to live there.

Summary of Example Facts
Current Fair Market Value $250,000
Cost of Home with Improvements $150,000
Potential Capital Gain $100,000
Potential Taxes: 15% $15,000

What to Plan for -
Lifetime Gift Tax Exemption $1,000,000
Home Exemption $250,000
Annual Gift Limit $11,000
Gift Limit with Spouse $22,000