Preserving family tradition and effective tax planning may not often intersect. But when parents give the equity in a home to their children, they may be able to accomplish both goals.
“Among the benefits to giving a home include transferring a place full of memories and sentimental value to those who appreciate it as well as providing a place for a child and his or her family to live,” says Michael Gerson, Senior Wealth Planning Strategist for Wells Fargo Private Bank. “You’re preserving the family’s ability to enjoy the home for a long time to come.”
“In addition,” he says, “you’re getting a valuable and potentially appreciating asset out of the estate, which can have substantial estate tax savings.”
Benefits of making a gift of 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 exclusion. (Passed at the end of 2017, the Tax Cuts and Jobs Act raised the estate tax exclusion to $11.4 million in 2019; that exclusion is scheduled to be adjusted annually for inflation until cut in half in 2026 unless new legislation is passed.)
Options for completing a gift of equity
For the most part, the gift giving process can be simple. But there are a number of considerations, including potential capital gain issues in some types of transfers where the home is subject to debt.
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. (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 of this potential 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 assumption means the transaction is part-gift, part-sale, and there could be income tax consequences for the parent,” Gerson says. A $1 million house with a $300,000 mortgage, for example, is considered a gift of just $700,000.
To give 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, each parent can give each child up to $15,000 per year beginning in 2018 without this counting against their lifetime exclusion of $11.4 million per individual. Amounts over that will be debited against the estate tax exclusion. [Both the estate/gift exclusion and generation-skipping transfer (GST) exemption are currently slated to increase by a cost-of-living adjustment every year but are subject to a 50% cut in 2026, one more good reason to stay connected with your tax advisor as you make decisions.]
“This is a compliance and tracking issue to make sure you’re not giving too much away,” Gerson says. Many of his clients, he says, made substantial gifts to their children in recent years because they feared potential changes in the gift and estate tax rules. “They may not have the full $11.4 million available because they’ve used a big chunk of it,” he adds. “They need to be very aware of that when they make future gifts.”
There are other tax considerations: If parents give home equity today, the children take the parents’ original tax cost 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,” Gerson 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 tenancy-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, so for tax purposes the gift potentially may be a fraction of the current value. “Even if the house triples in value, there’s no further gift amount, and it’s out of the estate,” Gerson says. “However, if the parents do not survive the term, for estate tax purposes they are effectively treated as if they never made the gift. In such case, they are no worse off than if they had done nothing–so some parents interested in this planning may potentially view this type of trust as a no-lose proposition.”
Please consult your financial professionals including a tax advisor to determine which, if any, strategy is appropriate for your unique situation.