The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys

gift, income tax, estate planning

“Son, I am sick and getting old, so fill out a deed to transfer my house into your name now.”

With the increase of the federal estate tax exemption to $5,340,000 in 2014, most taxpayers are not subject to federal estate taxes.  The focus for many now has shifted to the income tax implications that arise when wealth passes to the next generation.  With no regard to the income tax implications, many times elderly people get the idea that the transfer of real estate to children during their lifetime is a good idea in trying to avoid probate and to make things easier for loved ones. Even uninformed realtors, attorneys and other financial advisers sometime make such a recommendation without knowing the tax impact.  However well-meaning, this uninformed strategy can have disastrous income tax results for the children recipients of such ill-conceived lifetime gifts.

Basis Rules:

It is important to understand the following income tax basis rules for calculating gain or loss:

  • Lifetime Gifts:  Children who receive lifetime gifts take a carryover basis in the property received.  The carryover basis is determined by what the maker of the gift originally paid for the asset plus any improvements made to the property.
  • Bequest At Death:  Beneficiaries who receive assets at the decedent’s death get a step up in basis to the date of death value of such assets received.

Basis Rules:  Illustrating How These Rules Operate

Example:  DIY Dad wants to avoid probate and to transfer during his lifetime his real estate to his son, Sad Son.  DIY Dad bought his house in the 1970s for $17,000 and made improvements during the years of $23,000.  As a result his adjusted basis is $40,000.  The house is now worth $540,000.  To save lawyer fees, DIY Dad asks Sad Son to draft a deed to transfer the property.  Sad Son does so and DIY Dad signs the deed and has it recorded with the recorder of deeds.

  • Since this was a lifetime gift, Sad Son takes a carryover basis for the house of $40,000.  Sad Son sells the house for $540,000 shortly afterwards and has a capital gain of $500,000 which he surprisingly  and shockingly learns from his accountant will cost him $100,000 (20% x $500,000) in federal taxes alone.  His accountant tells him there will also be state income taxes on this gain. Since Sad Son is a Pennsylvania resident, he will pay an extra $15,350 in Pennsylvania income taxes.  Total Taxes: $115,350.
    • Form 709:  Any lifetime gifts of over $14,000 require the filing of a Form 709, United States Gift Tax Return, in the year of the gift.  It should also be noted the IRS now checks recorded deeds.  For more on the IRS policing this area please see IRS Checking Real Estate Transfers For Unreported Gifts.
  • Alternate Universe:  DIY Dad consults with his tax/estate attorney who drafts a will that provides for the transfer of his house at death to Sad Son. Sad Son (who now legally changes his name to Happy) Son, has a basis of $540,000 upon his receipt of the house from the estate.  Happy Son, now sells the house and has zero, yes, zero capital gain (Sale Price $540,000 less basis of $540,000 = 0)!
    • Note: Certain states have inheritance taxes.  For example, in Pennsylvania there would be a 4.5% inheritance tax on the real estate, but this is a smaller cost than the capital gains tax that results from taking a carryover basis via a lifetime gift.
  • Fall Back Solutions:
    • If Sad Son stays in the house long enough to qualify the house as his primary residence and all statutory requirements for exclusion are met, he may then exclude $250,000 of the gain on the sale of the house once he sells the house.  If married and all statutory requirements are satisfied,  Sad Sam may be entitled to a $500,000 exclusion.
    • If Sad Son owns the house until he dies, then his children would be entitled to a step-up in basis in the property at his death.
    • If Sad Son converts the house to a rental property and then later sells this property as part of a Section 1031 like-kind exchange, gain can be deferred.  If he later dies with the swapped property, such property will get a stepped up in basis to the date of death value.  This will cut income taxes to the estate or family members who later sell the property.

When Lifetime Gifts Make Sense

It is important to understand that in some situations gift giving may make sense.  The following examples come to mind and there may be others depending upon the situation:

  • Rapidly Appreciating Assets:  If assets will be rapidly appreciating in value in the future, developing a gift giving program may be a better strategy in spite of any loss in step up in basis.  It all depends on the particular factual situation presented.
  • Taking Advantage of Tax Strategies:  In a business context, gifting shares to take advantage of tax breaks associated with the lack of marketability and minority interest discounts may cut estate taxes.  For more on these and other gift giving strategies, please read Gift Giving: Tax Advantages.
  • Gifts In A Bad Economy or Distressed Industry:  Also, in a bad economy or a distressed industry, making gifts may make sense.  For a discussion on this topic readers may be interested in Gifting Shares of Stock In A Bad Economy.
Gifting Shares of Stock In A Bad Economy
Gifting Shares of Stock In A Bad Economy

Medicaid Caveat

This discussion does not explore any Medicaid qualification issues and such considerations should be explored with an elder law attorney specializing in this area.

Bottom Line

The key point of this discussion is that making transfers just to avoid probate can result in a tax disaster for your family.  Do not do it yourself.  Each taxpayer’s particular situation is unique and should be looked at by trained professionals to develop a workable, comprehensive and integrated estate and income tax plan. Get a tax or estates attorney along with your CPA and financial adviser to develop a plan that reduces taxes while still accomplishing your overall financial and estate goals for your family.


Disclosure and Disclaimer:
As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws. This article has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm’s full disclaimer.

Copyright © 2014 – Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved. 

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40 responses to “The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys

  1. Great article. Thanks for the info, you made it easy to understand. BTW, if anyone needs to fill out a form 709, I found a blank form here http://goo.gl/1oaNsy. This site PDFfiller also has some tutorials how to fill it out and a few related tax forms that you might find useful.

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  2. Great read especially on the illustration with DIY Dad and son. More people need to know this crucial information, in my line of work very few do. Thanks for sharing.

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  3. I am very pleased to find this blog. I want to thank for your time for this wonderful read!!! Keep Sharing, I’ll surely be looking for more.

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  4. I like reading through a post that will make people think.
    Also, many thanks for permitting me to comment!

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  15. Steven:

    I have often observed that many of these transactions occur because a client talks to a neighbor or enters counsel’s office and simply asks for a quit-claim instrument. My aunt, a number of years ago, took such an action resulting in her loss of preferential State property tax treatment without even considering the State inheritance and gift tax nor federal tax issues. Sadly, not only are there problems regarding “self help,” but our colleagues act as scrivener charging fees for these instruments without giving counsel as to effect and ramifications (assuming they have knowledge in these areas). Similarly, I have observed powers of attorney treated the same way. By analogy, it is no different than handing a six year old child a loaded handgun and saying “go play.”

    Tom Norris
    Nashvllle, TN

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  16. Great blog ! Really useful information about basis implications. You have very carefully laid out the issues here. Thanks for sharing.

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  18. Nice article, however section 2036 will cause the residence to be included in parent’s estate if parent gifted the property and continued to live in the home up to parent’s death thereby gaining a basis step up. Therefore the gift during lifetime does not necessarily preclude the basis step up.

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    • Hey Jim, I did not include that as part of the facts so to keep the article simple. However, you are absolutely correct as to the impact of Section 2036 but my facts did not state that DIY Dad continued to live there. Section 2036 issues are another topic. For example, if fair market rent is charged then there would be no Section 2036 inclusion. But your perceptive point is right on the money! Thanks for raising this issue. Thanks for stopping by and leaving your insightful comments!

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  19. Great article with very informative material presented in a very easy to understand writing style. Thanks for sharing this.

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  20. Hi Steve, I work in CA with an estate law attorney. In CA we use a trust to avoid probate and to pass real property on to heirs. An estate with real property in excess of $150,000 would go to probate on behalf of heirs were the decedent to die with or without a Will. The trust is a blessing for estate heirs whose parents had estates well below the $5,300,000.

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    • Hey Jim, thanks for stopping by and leaving this important comment. The key to this strategy is to make sure that this is a revocable trust. If the trust is revocable then it is included in the decedent’s taxable estate. As a result any and all assets in such trust would get a stepped up basis to the date of death of the settlor (maker of the trust). So under your scenario, you would avoid probate AND get a step-up in basis. The best of both worlds.

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  21. New Estate Atty

    Really good post. Thanks for this, I just had a PC call me about this exact situation.

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  22. Steven,
    If the intent of the property owner is to (ultimately) transfer ownership to the owner’s children, wouldn’t a trust be a good means of accomplishing that objective, as the trust could be structured so that the children get the stepped-up basis? I realize that trusts can add many complications at the front-end, but the right form of one may be well worth it in the long run for all concerned. But that’s a subject for another article (or several).

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    • Ralph, trusts definitely have a place in estate planning. For young children, a trust would almost seem to be imperative in most cases. However, trusts holding a residence for adult children may not make sense. It really depends on the particular factual setting. This is where attorney input and experience can help guide clients to make the best and most practical decisions regarding ownership and transfer of property. This is a very important non-tax consideration.

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  23. Hi Steve,

    Loved the article! I can relate to the story…a relative on my wife’s side of the family did the DIY sale to her daughter but hasn’t passed away yet. I had told them in the past to always talk to me before doing something with real estate (they had a shore house they sold through an unscrupulous agent in Ocean city there who was trying to screw them and her aunt was asking me what to do). So her daughter (being the know it all that she is) had her mother transfer the house to her name then turned around and sold it (I guess you can guess who WASN’T the Realtor on that one). I guess she’ll be in for a big surprised after listening to her friend who was the Realtor who she used.

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    • Hey John, so nice to hear from you and get a realtor’s point of view. Your comments show that this happens more than people think. Hopefully this post will help readers to understand that such actions can have negative tax impacts on the recipients of these ill-conceived gifts. Thanks so much for your real life example John.

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  24. Retired attorney in MN

    Great post. I’m going to bookmark your blog. Sometime I’d like you to touch upon the unfairness of giving new credits to people who sell residential real estate every five years or so & sticking it to settled people who’ve lived in house for 40 years &, unless I misunderstand the law, are in effect discouraged from selling during lifetime by the cap gains tax implications of a gain of, say, $800,000 (from $75,000 purchase price). People in this “predicament” are discouraged by the law from giving or selling. They’re, to a certain extent, “boxed in.” Or am I wrong?

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    • You make a very valid point. Although it will not totally knock out gains, keeping track of improvements to the residence can increase basis more than most think. Trees, outdoor lighting, new kitchens, bathrooms, finished basements, decks should be added to basis and proper documentation preserved. In many cases this can eliminate any gain above the thresholds.
      However, you are right that this is a limited exclusion that does favor those who move around and meet the various tests for exclusion. Adding insult to injury occurs when one spouse dies and the exemption is back to $250,000. However, there may be a partial step up in basis where the house was owned jointly.
      So to answer your question, in a situation of highly appreciated residences parties are somewhat boxed in as you state. Borrowing against the house may be a way to free up equity, at a cost, however.
      Thanks for your insightful comments and please add your email address on the right hand column to get instant updates of my new posts.

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  26. Very interesting! I don’t think I’ll be inheriting any real estate, but will pass the post on to friends as they enter this stage of life!

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