Can you avoid capital gains tax by gifting?

Can you avoid capital gains tax by gifting? A reader wants to know if they can reduce a potential capital gains tax bill by gifting a portion of the home to his daughter.

Q: My daughter, my wife and I are co-owners of the home. Our daughter lived with us until 2021.

We bought the home for $350,000 around 20 years ago. When we refinanced our home loan four years ago, our daughter became a co-borrower and co-owner on the home. Do we have to pay capital gain tax for the home owned by me, my wife and my daughter when the home is sold?

What qualifies for the capital gains tax exclusion when it comes to property

We’re wondering how the capital gains exclusion would work in this case. We understand $500,000 is an exclusion for joint tax returns that would apply to my wife and me. My daughter would get a $250,000 exclusion on her own return. If we sell the home for $1.2 million, can we distribute the capital gain on the basis of $500,000 to us and $250,000 to her? Does this work?

We are trying to explore the best possible way to lower the tax.

Who qualifies to avoid capital gains tax by gifting property

A: The Internal Revenue Service rule states that you are entitled to exclude from profit from the sale of your primary residence up to $250,000 if you are single or $500,000 if you are married. That’s only one part of the equation. The other part is that you must have owned your home as your primary residence and lived in it for two out of the last five years.

You’d have to determine whether your daughter qualifies as we can’t tell from your email if she lived in the home for two out of the last five years. If she did, it seems the three of you would qualify for the exclusion. However, your daughter didn’t buy the home 20 years ago for $350,000. You put her on title four years ago and you need to make sure that she satisfies the two year primary residence requirement as an owner.

Calculating the cost basis of a gift

Assuming she has satisfied the IRS requirements, let’s figure out her basis since you essentially gave her a share of the home fairly recently. Your cost basis is the $350,000 you paid for the home. When you added her to the title, you gave her one-third of the property.

According to the IRS, “If the FMV [fair market value] of the property at the time the donor made the gift is equal to or greater than the donor’s adjusted basis, your adjusted basis is the donor’s adjusted basis just before the donor made the gift, increased or decreased by any required adjustments to basis while you held the property.”

In other words, unless you made significant, material changes to the property (think adding a room or replacing the plumbing), you gave her one-third of the property at the $350,000 cost basis. It’s as if she bought her share of the property for $116,667.

Paying capital gains tax: First figure out whether there’s a profit

Let’s say you sell the property for $1.2 million net, meaning after subtracting commissions, fees and other costs of sale. At that point, you’d subtract the cost of purchase ($350,000) and any material improvements made over the years (let’s assume you haven’t touched the place, just to make it simple). So, the true profit would be $850,000.

You and your wife’s share of the profits would be $566,667. Your daughter’s share of the profit would be $283,333. If you are able to take up to $500,000 in profits tax free, you would only owe capital gains tax on $66,667. Your daughter would owe capital gains tax on $33,333.

We assumed in our calculations that you didn’t spend a dime over the years to improve your property. But, what if you had? If you needed to replace mechanical systems or added onto the property, you might easily have spent more than $100,000, which could bring down the actual profit below the tax exclusion threshold.

You should review your expenses and talk to your tax preparer to go over the numbers. You’ll want to make sure you, your wife and your daughter qualify for the tax exclusion, and that you know exactly what the sale will mean for your tax liability. And, be sure to check out IRS Publication 551, Basis of Assets.