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.
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. Continue reading