Updated September 2016 — Preserving family tradition and effective tax planning may not often intersect. But when parents gift the equity in a home to their children, they may be able to accomplish both goals.
"One benefit is to give a home that may have sentimental value to someone in your family, as well as providing them with a place to live," says Matthew E. Brady, Senior Director of Planning for Wells Fargo Private Bank in San Francisco. "You're preserving the family's ability to use it for a long time to come."
"In addition," he says, "you're getting a valuable and appreciating asset out of the estate, which can have substantial estate tax savings."
Benefits of gifting equity
The current state of the residential real estate market may make the idea particularly timely. While housing markets have been in recovery mode for more than a year in many areas, home prices still may be below all-time peaks. By giving equity in a home now, parents can pass along the gift at today's prices.
Consider a scenario where parents own a home valued at $1 million and intend to include it as part of their estate. If the home continues to grow in value — for example, from $1 million to $2 million over the parents' remaining lives — as part of the estate that $2 million figure would increase the likelihood of the estate's value eclipsing the estate tax exemption. (The estate tax exemption has risen to $5.45 million for 2016.)
Options for completing a gift of equity
For the most part, the gifting process can be simple. But there are a number of considerations, including potential capital gain issues in some types of transfers.
One option for the transfer, if the parents have the liquidity, is for them to pay off the mortgage first. If the parents want the children to have some responsibility for the cost of the home, they could become the mortgage lender to their children for a portion of the home's value, thus deferring income tax consequences, Brady says. (Parents can lend to children at potentially more advantageous interest rates than the children could obtain from a commercial lender.)
But borrowing from the parents to finance the transfer would likely be taxed as a sale of the property to the extent of the mortgage, raising potential capital gain issues to the parents. Federal tax law (IRC § 121) permits a married couple to exclude up to $500,000 in gain from taxable income, but parents should be careful about any sale transaction.
Rather than paying down the mortgage, children might assume the mortgage as part of a gift. That also would bring up the sale issue; the Internal Revenue Service considers the parents as having accepted a partial payment for the property.
"That means the transaction is part-gift, part-sale, and there could be income tax consequences for the parent," Brady says. A $1 million house with a $300,000 mortgage, for example, is considered a gift of just $700,000.
To gift the house, but keep the mortgage, the parents need permission from the mortgage lender. (And, in the previous example, the value of the gift is $1 million if the mortgage stays with the parents.)
Take stock of the tax consequences
The value of the home's equity is subject to rules on gift and estate taxes. Based on the published amounts for 2016, each parent can give each child gifts of up to $14,000 per year without this counting against their lifetime exemption of $5.45 million. Amounts over that will be debited against the estate tax exemption.
"This is a compliance and tracking issue to make sure you're not giving too much away," Brady says. Many of his clients, he says, made substantial gifts to their children in recent years because they feared potential changes in the gift tax rules. "They may not have the full $5.45 million available to them anymore because they've used a big chunk of it," he adds. "They need to be very cognizant of that when they make future gifts."
There are other tax considerations: If parents gift home equity today, the children take the parents' original tax basis (plus any capital improvements). That may expose the children to possible larger capital gains taxes in some circumstances.
If the house were passed along at death, as part of an estate, it would be valued on a "step-up" basis, resetting at the market value on transfer and reducing potential future gains.
"There's always a trade-off between avoiding estate taxes and having to pay capital gains taxes," Brady says. "Traditionally, the trade-off favored capital gains taxes because the estate tax rate was so much higher: up to 55 percent in the old days. Today, it's 40 percent. And the capital gains rate can be more substantial than it used to be, particularly in states like California. It's a lot closer call than it used to be."
Options for family needs
If you are interested in giving a gift of equity, but want to split it between children or need to stay in the house after you make the gift, there are guidelines for those situations as well.
The gift can be made to more than one child, but that can create a tenant-in-common situation, where the children share not just ownership but also management of the property. Such arrangements should be thoroughly discussed among the parties involved.
Parents who want to continue to live in the home after the gift may use what's called a Qualified Personal Residence Trust. The home is placed into a trust to benefit the children, but the parents reserve right to live in the house for a period of time — 15 years, for example. Because of that right, the gift is considered less valuable. But the value of the home is still measured at the time of the gift, not when the children move in. "Even if the house tripled in value, there's no further gift amount, and it's out of the estate," Brady says.
Please consult your financial professionals including a tax advisor to determine which, if any, strategy is appropriate for your unique situation.