Be sure to consider the taxes you'll owe if you want to give the family home to an adult child.
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Transferring a home to adult children is not quite as easy as giving them the keys and letting them move in. No matter how you do it, the taxman wants his cut, whether through estate and gift taxes or those for property and income, both federal and state.
The most common way to transfer a property is for the kids to inherit it when the parent dies. Some parents will also make an outright gift of the home to their child, who can incur higher property taxes in states that treat the gift as a sale. It's also possible to finance the child's purchase of the home or sell the property at a discount, known as a bargain sale.
These last two options might seem like a nice solution, as many adult children struggle to buy a home at today's soaring prices, but crunch the numbers with an accountant or financial adviser first. These transactions can get complicated fast, says Lawrence Pon, an enrolled agent and a certified public accountant in Redwood City, Calif.
Here's how they work.
If you sell your home to your child for less than what it's worth, the IRS considers the difference between the fair market value and the sale price a gift. For example, if you sell a $1 million house to your child for $600,000, that $400,000 discount is deemed a gift. You won't owe federal gift tax on the $400,000 unless your total lifetime gifts exceed the federal estate and gift tax exemption of $11.7 million in 2021, but you must still file a federal gift tax return on IRS Form 709.
Sounds simple, right? Not exactly. Now, using the same example, consider the federal income tax consequences. Let's say the parents are married, bought the home years ago and have a $200,000 tax basis in it. When they sell the house at a bargain price to the child, the tax basis gets split proportionately. In this example, 40% of the basis ($80,000) is allocated to the gift and 60% ($120,000) to the sale. To determine the gain or loss from the sale, the sale-allocated tax basis is subtracted from the sale proceeds.
In this example, the parent's $480,000 gain ($600,000 minus $120,000) is nontaxable because of the home sale exclusion. Homeowners who owned and used their principal residence for at least two of the five years before the sale can exclude up to $250,000 of the gain ($500,000 if married) from their income. Pon suggests maximizing the tax benefit of this exclusion.
The child isn't taxed on the gift portion, but unlike inherited property, gifted property doesn't get a stepped-up tax basis. In a bargain sale, the child gets a lower tax basis in the home, in this case $680,000 ($600,000 plus $80,000). If the child were to buy the home at its full $1 million value, the child's tax basis would be $1 million.
