Gifting Real Estate With Minimum Gift Taxes

Q: My parents own a rental house and they want to gift it to me and my wife. The house was recently appraised at $160,000.

They’d like to use the annual exclusion and give us $44,000 worth of the house’s value each year until they reach the appraised value. This should take about four years.

We’re not quite sure how to do this. Is a portion of the house deeded to us each year? Can the title be transferred solely to us and then they start gifting the house to us? If we live in the house for two years will we avoid having to pay any capital gains taxes based on what they originally bought the house for and what it is worth at time of sale?

If you can help us with these questions I will be eternally grateful. Thanks!

A: I’m often asked how to gift property to children and grandchildren. While there are some benefits in waiting to pass down this kind of property as an inheritance, some parents want to gift it to their children while they are alive and can see them using it. They may also want to get the property out of their estate for tax purposes.

If you want to give your children real estate (or stock), and not pay any penalties to the IRS, you have to take a few important steps.

According to Georgia Loukas Demeros, an estate attorney based in Chicago, the parents in this case have already taken an important first step: They had the property appraised by a professional appraiser. That will help avoid any question of value by the IRS.

Once you have the appraisal, fractional interest equal to the annual exclusion amount can be gifted. Under current tax law, that amount is $11,000 per person, for a total of $44,000 from a married couple to a married couple, or $66,000 from a married couple to a married couple with two children.

In this case, if the house has a value of $160,000, then a 7.5 percent interest in the property, or $44,000 of a house worth $160,000, can be gifted each year.

How do you deliver the gift? It’s hard to gift-wrap a quarter-share in a house.

“The parents can prepare a deed to their son and his wife for the fractional interest in the property that is gifted,†Loukas Demeros explained. In this case, “it will take four years to complete the transfer and 4 deeds, provided there is no change in value.â€

But that could be a sticking point. If the property continues to appreciate at a rate of 5 percent per year, the property would be worth $168,000 in the second year, $176,400 the third year, and $185,220 the third year. If property in the area appreciates at a greater rate, then the rental property will be worth even more.

Which means it might take five or six years to gift the entire value of the property.

“It is the value on the date of each gift that is used not the value on the date of the first gift,†Loukas Demeros observed.

So if the property appreciates from year to year, those giving the property might need to obtain a new appraisal of the property’s value each year in order to readjust the amount of the gift.

Loukas Demeros recommends talking to your tax preparer or accountant to determine if a gift tax return needs to be filed by April 15th of the year following the gift, or April 15, 2005 for gifts given in 2004.

“Certain factors, like the consent of the spouse giving the gift or discounts on the valuation of the property, may trigger the requirement to file a gift tax return even though the amount gifted is within the annual exclusion amount,†she noted.

Finally, the children receiving the gift in this case wonder if they can live in the rental property for two years and then sell it, excluding any profit they would make on the sale.

According to Loukas Demeros, current tax law permits a homeowner who has lived in the house as his or her personal residence for at least two of the last five years to keep up to $250,000 in profits (or up to $500,000 if the homeowners are married) tax free when the property is sold.

“If your reader and his spouse occupied the house for two years, they would be able to exclude the gain in an amount equal to the percentage of the home they owned for two years,†Loukas Demeros explained. So if approximately 50 percent of the property had been transferred after 2 years, the children would be able to exclude the profits on that portion of the property – with one big caveat.

The house that is being gifted isn’t the parents’ personal residence. It’s a rental property. Presumably, the parents depreciated the property during the years in which they held it.

And here’s where there is a big difference between receiving a gift of property and inheriting property: When you gift property to your children, whatever you paid for the property essentially becomes (for tax purposes) what your children paid for the property.

If you inherit property from your parents, your tax basis becomes whatever the property was worth on the open market the day you inherited it.

So if the parents paid $50,000 for the property that is now worth $160,000, when they gift the property to their children, the tax basis would be $50,000 minus any depreciation that had been taken.

If they inherit the property, their tax basis would be $160,000, according to Loukas Demeros.

Even if the children live in the property for two years after receiving the entire property as a gift (or, for a total of six years), they “may be unable to exclude the entire amount of the gain. The depreciation previously taken on the property would limit the gain that could be excluded,†Loukas Demeros added.

That’s why it’s important to sit down with your tax preparer or accountant before making any big gifts. You have to determine whether it’s worth gifting the property now, or including it in your estate later on.

There are other ways to transfer fractional shares in real estate, including the use of trusts. An estate attorney can help you work out which want will have the most favorable impact on your taxes and your estate.

Dec. 27, 2004.


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