Minimizing Estate and Income Taxes on your House

Transferring your Home to Your Children Without Tax

Many people would like to give their home to their children.  Many would like to stay in their house as long as possible.  For many, the house is a significant appreciated asset and they would like to minimize taxes on it.   Achieving this takes some planning.  Below are some of the options.

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Minimizing Estate Tax on Your House
Stay in your Home Until you Die

You can stay in your home until you die and this is normally your best option.  It may also be a good option to retain the house even if you aren't living in it or rent it out.

As long as your estate assets are below the estate tax exemption amount (about $5.5M in 2017) this is your best strategy.  There won't be any tax and the basis of the house will be stepped up to fair market value on your date of death.  

If you sell the house before you die, you may have to pay tax on the gain in the house (hold it till death and you don't).  This strategy avoids all the tax on the appreciation of the house.

Here is the way it works.  When you die, your home's tax basis will be stepped up to fair market value as of the date of death. So you and your children escape income tax on all the appreciation.

Since the value of your estate is below the estate tax exemption, there will be no estate tax.  Therefore, under this strategy there is no income tax and no estate tax.

 There may be some state estate tax, depending upon the state the house is in.  Currently, New York's estate tax exemption is about the same as the federal exemption, but Connecticut's 2017 exemption is only $2M, so there can be some state tax.

After you death, the children are free to move into the house, or sell it and keep the cash while owing no tax.  If they do move into the house, their tax basis for calculating the gain or loss on subsequent sales will be the home's fair market value at the time of your death.

Don't Gift the House if Possible

If you intend to still live in the house, don't  gift the house to your children; you are at risk of having it pulled back into the estate.  You would have to pay a market-rate rent to your child in the interim.

The way around this problem is with a qualified personal residence trust, as discussed below, which complicates things.

Outright Gift of Your Home

If you intend to move out of your home, you can give the property to your child. However, you will utilize some of your unified federal gift and estate tax exemption ($5.49 million for 2017).  Moreover, your child will only assume your basis at the time of the gift.  If you held it to death the basis would be increased to fair market value.  Ultimately, that means they will have to pay more tax.

One benefit is the you would get any future appreciation in the home's value out of your estate if it is taxable.

Sale of Your Home for a Bargain Price

If you sell a home to a third party for less than fair market value, you've made a bad deal. However, if you sell to a relative, the difference between the fair market value and the sale price is a gift.

For example, if your house is worth $600,000 and you sell it to your child for $200,000, you just made a gift of $400,000. You can use your $14,000 annual gift exclusion against this, but the rest (386,000) reduces your unified federal gift and estate tax exemption ($5.49 million for 2017).

Your child receives a lower basis than if  you held it to death, which may result in additional taxes at a later time.

This might be a good result,  if the property is expected to appreciate, because the sale removes all future appreciation from your taxable estate.

Sale of Your Home With Seller Financing

Instead of making a bargain sale, consider making an installment sale for full market value instead. This can still meet your primary objective of transferring the home to your child in a way he or she can afford -- probably with better tax consequences.

Here's how to do it.  You sell the property to your son or daughter for a relatively small down payment and carry a note for the balance of the purchase price. Let's again say the house is worth $400,000 and your child can afford to pay $40,000 down. So you take back a note for $360,000, just as if it were a mortgage. The loan should be properly documented, secured with a mortage, and have a written note. 

You need to charge at least the applicable federal rate (or AFR) on the loan. That rate is always well below the average commercial mortgage rate.

If you want to, you can then ease your child's financial burden by making gifts under the annual $14,000 gift-tax exclusion rule. The payments have to be made.  If you simply forgive some of the payments, the IRS may recast the entire arrangement as a bargain sale (with the less-desirable tax consequences explained earlier).

Income-tax-wise, you are treated as making a sale for $400,000. Assuming you qualify for the $250,000/$500,000 exclusion, you should be able to avoid federal capital gains tax. You will owe income tax on your interest income from the note and your child will get a deduction for it. Your child's tax basis on the property is now the full $400,000 purchase price, which reduces the chance he or she will owe any tax when the home is sold.  

The sale removes from your taxable estate any future appreciation in the value of the home.

You can forgive the note in your Will and your child will be treated as receiving a bequest.

What if You Want to Live in Your Home?

Unfortunately, the IRS gets suspicious when you transfer your home to a relative and then continue to live there. So be careful and follow the legal steps.  

One strategy is to make a seller-financed sale at fair market value sale to your child, as detailed above, and then rent the property back at fair market value.

In a perfect world, this would remove the home's future appreciation from your taxable estate and you could shelter all or part of your gain with the $250,000 (for singles) or $500,000 (for married couples) home sale exclusion.

The rental payments to your child could, in effect, finance at least part of the cost of buying the home. The payments would be nondeductible to you and taxable income to your child. But he or she could claim rental property depreciation write-offs and other tax benefits.

If you sell for less than fair market value  or pay below-market rent, an the IRS can seek too include the full date-of-death value of the home in your taxable estate. 

In sum, you can transfer ownership to your child and stay in the house, but make sure you make a fair market value sale (as opposed to any gift or bargain sale arrangement). Then be sure to pay market rent to your child.

You can still make $14,000 annual tax-free gifts to help your child out.

Keep these acts of generosity separate from your dealings regarding the sale or rental of the house. In other words, don't forgive payments on your seller-financed note and don't include gifts in your rent checks.

Qualified Personal Residence Trusts

There is another way you can make an IRS-approved gift of your home while still living there. That is with a qualified personal residence trust (or QPRT). Using a QPRT potentially allows you to get the residence out of your taxable estate without moving out — even though you have not made a full fair market value sale to your child. 

Here's how a QPRT works. Say you want to  give your  $1 million beachfront home to your two daughters. This strategy would require the you to put your home into an irrevocable trust for several years, while he continues to live in it. Through a complex IRS calculation based on interest rates, the length of the trust and his age, the IRS values his right to live in the house at, say, $600,000.

For the purposes of his taxable estate, that reduces the value of your house down to just $400,000 — regardless of how much the house appreciates in the meantime. (That $400,000, though, comes out of the your unified federal gift and estate tax exemption.) When the trust is up after the stipulated number of years, if you choose to continue living there, you can pay your daughters rent, further reducing the size of his taxable estate.

Of course, if you have a poor relationship with your kids, you might find yourself out on the street since this is an irrevocable trust.

For the tax scheme to work, you have to outlive the trust.  If you die before the term of the trust expires, the full date-of-death value of the house is included in your taxable estate and your heirs receive no estate tax benefit.

Federal Estate Exemption and Tax Rate

For 2017, the federal estate and gift tax exemption is $5.49 million per person, up from $5.45 million in 2016. That means an individual can leave $5.49 million to his heirs and pay no federal estate or gift tax. A married couple will be able to shield about $11 million ($10.98 million) from federal estate and gift taxes.

The federal estate and gift tax exemptions rise with inflation, and are changed every year.

If you are lucky enough to have to worry about the Federal Estate Tax, the rate starts at 18% and quickly ratchets up to 40%.

Federal Gift Exclusion

The federal annual gift exclusion remains at $14,000 for 2017.

Connecticut Estate Exemption and Tax Rate

In 2017, the Connecticut estate tax starts at $2M.  The rate starts at 7.2% and goes up to 12%.

Because the exemption in Connecticut is only $2M and the federal exemption is almost $5.5M, you can have no federal liability and still incur a Connecticut tax liability.

New York Estate Exemption and Tax Rate

New York estate tax starts at a $5.25M (changed by a 3-14 law rising to the full federal amount-in on 1-1-19).  The rate starts at 5% and goes up to 16%.  

Therefore, New York is generally the same as the federal exemption.  However, beware the New York estate tax cliff where the entire estate is taxed if it goes over the exemption amount.

Elder, Wills, Estates, Trusts, Special Needs Tax & Business Law; Attorney John Sweeney

Sweeney Legal, LLC, provides legal, practical, and business counsel to Seniors, families, and businesses in the Fairfield, Connecticut area, including the communities of Bridgeport, Bethel, Brookfield, Danbury, Darien, Easton, Fairfield, New Canaan, Newtown, Norwalk, Redding, Ridgefield, Stamford, Weston, Westport and Wilton. John is also licensed in New York serving Westchester County including the towns of Bedford, Lewisboro, Mount Kisco, North Salem, Pound Ridge, and Somers.

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