Tax Consequences for Gifting Properties – Gift Tax and Income Tax

Recently, a wealthy friend of mine has reached out to me for tax guidance, he wants to gift one of his properties to his daughter. Since he asked the questions, I’ve realized that a lot of parents out there probably have the same questions. This post will provide the answer on tax consequences for gifting a property to others (non-spouse) including gift tax and income tax.

The GIFT

Kevin bought a home 10 years ago with his daughter, Rachel for $900,000, each person has 50% ownership on the home. Kevin now wants to gift his 50% ownership which is now worth $750,000 (the house market value is about $1,500,000) to Rachel. The question he has is whether he will end up owing any taxes if he makes the transfer.

The answer is “it depends”

The property has no mortgage

If there’s no mortgage remaining on the home, when Kevin transfers his 50% to Rachel, Kevin is making a gift to Rachel of 50% of the current fair market value at $750,000.

Gift Tax Consequences.

Currently the annual gift tax exemption is $15,000. Kevin is deemed to make a taxable gift of $735,000 ($750,000 – $15,000). Therefore, Kevin would need to file a gift tax return and elect to use $735,000 of his lifetime exemption. For 2021, the estate and lifetime gift tax exemption is $11.7 million per individual. By doing this way allows Kevin to transfer his ownership to his daughter without incurring any current tax liability and $735,000 will be deducted from his lifetime gift tax exemption.

Income Tax Consequences

In the future when Rachel sells the property, she may be subject to income taxes on the difference between the sale price and her basis in the property. However, Rachel will be eligible for the $250,000 capital gains exclusion at the time of sale.

Donee’s Basis

Since the transfer is a gift, the donee (Rachel) will take Kevin’s basis which is the 1/2 of purchase price ($450,000) and her own basis ($450,000) which is also the 1/2 of purchase price. Rachel’s basis is $900,000 and if she sells the house for $1,500,000, she has to pay the income tax on the gain of $600,000 ($1,500,000 – $900,000) unless she qualifies for $250,000 exemption (lives in the house as her primary residence for 2 years). See How to Minimize Tax on the Sale of Your Primary Residence for more information on how to qualify for $250,000 capital gain exemption.

What happens if the home is encumbered by a mortgage?

In this case, Rachel assumes 1/2 of the mortgage whether she signs the note to the lender or not. Moreover, Kevin is relieved from the portion of debt. As the result, the equity portion is considered as a gift; it is subject to gift tax and the mortgage assumption is considered as a sale.

Let’s use the same example as above except the home has a mortgage of $500,000

Gift Tax

When Kevin transfers 1/2 of his ownership in the property to Rachel, he makes a gift tax of as follows.

• Fair market value of his ownership: $750,000

(Less) 1/2 of the mortgage: $250,000

(Less) $15,000 annual gift tax exemption

Taxable Gift = $485,000

Although the taxable gift is $485,000, Kevin can file the gift tax return and elect to use $485,000 of his lifetime gift exemption to offset the tax liability.

Income tax from the sale part (mortgage assumption by donee)

Besides the gift tax issue, the donor (Kevin) realizes a gain for income tax purposes to the extent that the amount he “earns” in the “sale” exceeds his adjusted basis in the property. However, Kevin does not realize a loss if the amount he earns is less than his adjusted basis in the property.

Kevin’s adjusted basis equals 1/2 purchase price plus 1/2 of home improvement. To make it simple, there is no improvement made to the property. Kevin’s adjusted basis is $450,000 (1/2 of the purchase price). The sale price of his 1/2 ownership is 1/2 of the mortgage which is $250,000. Since Kevin’s basis is higher than the sale price, no loss is realized and no tax liability is incurred.

Donee’s Basis in the property

When a transaction is deemed to be both gift and sale, the basis equals

• (1) the larger of the donor’s basis or the amount paid by the donee for the property plus
• (2) a fractional amount of any gift taxes actually paid by the donor.

Back to the example,

(1) the donor’s (Kevin’s) basis = $450,000

The amount paid by the donee (Rachel) = $250,000

The larger amount of the two = $450,000

The donor didn’t actually paid any gift tax.

So Rachel’s basis in the house = $900,000 ($450,00 of her 1/2 ownership + $450,000 from Kevin’s gift)

Conclusion

Making a gift of property, such a transfer can have real and significant tax consequences. Be Cautious! Check with a Tax lawyer or Tax professional before making any property transfer to minimize the tax impact.