Buying a house in today’s overheated real estate market can be challenging — especially as mortgage rates are on the rise. But financially secure parents who are considering downsizing or relocating to greener pastures may want to consider transferring their homes to their adult children. Here are three options to consider.
1. Make an Outright Gift
If you’re feeling exceptionally generous, you might decide to simply give your existing home to your adult child. From a federal tax perspective, gifting a home in 2022 will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value (FMV) of the home you’d be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.
If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the FMV of the home minus the $16,000 annual exclusion. The remainder is the amount that would reduce your unified federal exemption. Do the same for your spouse’s separate exemption.
If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse. Plus, if the home continues to appreciate (a seemingly good bet), getting it out of your estate by giving it away is a smart estate planning strategy.
Important: Don’t make an outright gift of the home if you intend to continue living there until you die. In that scenario, expect the IRS to argue that the home’s full date-of-death FMV must be included in your estate for federal estate tax purposes, even if you paid fair market rent to your child. Also, beware of the so-called “three-year rule,” which requires assets gifted within three years of your death to be included in the value of your estate for tax purposes.
To illustrate how this alternative works, suppose you and your spouse own a home that’s worth $750,000, and neither of you has tapped into your $12.06 million unified federal exemption. You generously decide to make a joint gift of the property to your unmarried son.
For federal gift tax purposes, the joint gift is valued at $718,000 ($750,000 minus $32,000 for two annual gift exclusions). So, your $12.06 million unified federal exemption is reduced by $359,000 (half of $718,000). The same math applies to your spouse’s separate exemption. Neither you nor your spouse owe any federal gift tax because the gift is sheltered by your respective unified federal exemptions.
Your son takes over your presumably low tax basis in the property, which raises the odds that he’ll owe Uncle Sam when the home is eventually sold for a gain. However, if he lives in the home for at least two years and remains unmarried, he will qualify for the $250,000 single-filer federal home sale gain exclusion.
If your son were married, you and your spouse could decide to make a joint gift of the home to your son and his spouse. In this scenario, the joint gift would be valued at $686,000 for federal gift tax purposes ($750,000 minus $64,000 for four annual gift exclusions). So, your $12.06 million unified federal exemption would be reduced by $343,000 (half of $686,000). The same math would apply to your spouse’s separate exemption. Again, neither you nor your spouse owe any federal gift tax because the gift is sheltered by your respective unified federal exemptions.
Likewise, your son and his spouse would take over your presumably low tax basis in the property. And, if they live in the home for at least two years, they’ll qualify for the $500,000 joint-filer federal home sale gain exclusion.
2. Arrange a Bargain Sale
If you’re feeling generous, but not so generous that you want to simply give away your home, you might consider selling the home to your child for less than FMV. For federal gift tax purposes, you’re treated as making a gift of the difference between the home’s FMV and the bargain sale price. Here’s an example to show how this strategy will shake out from a federal tax perspective.
Let’s suppose you’re unmarried, and you haven’t yet tapped into your $12.06 million unified federal exemption. You sell your $750,000 residence to your unmarried daughter for $250,000.
In the eyes of the IRS, you’ve made a $484,000 gift ($750,000 FMV minus $250,000 bargain sale price minus the $16,000 annual gift tax exclusion). That reduces your $12.06 million unified federal gift and estate tax exemption by $484,000.
What about the federal income tax consequences of the bargain sale? To calculate your taxable gain or loss, subtract the tax basis of the home from the $250,000 sale price. Any loss is nondeductible. Any gain may be eligible for the $250,000 single-filer federal gain exclusion if you meet all the ground rules.
Your daughter’s tax basis in the home will be only $250,000. So, she’ll probably trigger a large gain when she sells the property. However, if she lives there at least two years and remains unmarried, she’ll qualify for her own $250,000 gain exclusion.
Important: Don’t make a bargain sale of your home if you intend to continue living there until you die. In that scenario, the IRS can be expected to argue that the home’s full date-of-death FMV remains in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.
3. Arrange a Full-Price Sale and Provide Seller Financing
If you don’t want to give your adult child free or cheap digs at your expense, you might consider selling the home to your offspring for its current FMV and then taking back a note for a big part of the purchase price. Done right, this seller-financed deal can give meaningful financial help to your son or daughter while also delivering the best tax results for you both.
To illustrate how this strategy works, suppose you and your spouse own a home that’s worth $750,000. You decide to sell your residence for its FMV to your married daughter and her spouse. The couple can handle a $150,000 down payment.
You agree to finance the remaining $600,000 by taking back a note for that amount. You’re feeling charitable and decide to charge the lowest interest rate the IRS allows without any complicated tax consequences. That’s the so-called applicable federal rate (AFR). AFRs change monthly in response to bond market conditions and are generally well below commercial rates.
For loans made in June 2022, the long-term AFR for loans of more than nine years is 3.11% (assuming annual compounding). The mid-term AFR for loans of more than three years but not more than nine years is 2.93% (assuming annual compounding).
So, for a loan made in June of 2022, you could take back a 30-year note that charges the long-term AFR of 3.11%. Alternatively, you could take back a nine-year note that charges the mid-term AFR of 2.93%. Either arrangement would be a money-saving deal for your daughter, compared to what would happen with a commercial lender.
What are the federal income tax results of using this strategy? In the eyes of the IRS, you simply sold your home for $750,000. Assuming you and your spouse qualify for the $500,000 federal home sale gain exclusion break, you’ll probably owe little or no federal income tax on the deal.
In addition, there are no gift tax consequences because you sold the home for FMV. Estate-tax-wise, the sale removes any future appreciation in the value of the home from your taxable estate.
Your daughter and her spouse will have a tax basis of $750,000. If the couple lives there for at least two years, they’ll qualify for the $500,000 joint-filer home sale gain exclusion, which should fully shelter any gain unless the home appreciates significantly.
As a bonus, if you’re feeling generous, you can make annual cash gifts to your daughter and her spouse to help them out financially. For 2022, the annual gift tax exclusion is $16,000. So, you and your spouse could gift $64,000 in cash to your daughter and her spouse ($16,000 times four) in 2022 without owing any gift tax or tapping into your respective $12.06 million unified federal exemptions.
The annual gift tax exclusion is adjusted for inflation in $1,000 increments. Based on the current rate of inflation, the exclusion will probably be at least $17,000 for 2023.
Beware: Don’t make indirect gifts in the form of accepting reduced payments or no payments on the note that’s owed to you. That would invite the IRS to recast the entire arrangement as a bargain sale of your home, with the suboptimal tax consequences explained above.
Important: Go through the legal process of securing the written note owed to you. Otherwise, your daughter won’t be able to treat the interest paid to you as deductible qualified residence interest. That’s because, if the note isn’t secured by the property, the interest payments will be considered nondeductible personal interest.
What’s Right for You?Parenting doesn’t necessarily end when your child graduates or gets married. Sometimes parents can lend a helping hand after children are well into adulthood. Contact your tax advisor to discuss these options and the related tax consequences.