With today’s home prices and the crazy real estate market, it’s likely difficult for your children to buy a home. And it’s conceivable that you are ready to move on from your existing home.
If this is true, consider the three options below.
Option 1: Make an Outright Gift
Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid!
Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.
If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.
If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.
If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.
Option 2: Arrange a Bargain Sale
Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.
Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.
Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you die. In these scenarios, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.
Option 3: Arrange Full-Price Sale with Seller Financing from You
The idea of giving your child a free house might be unappealing to you. Very well.
Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price.
Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).
AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In May 2022, the long-term AFR, for loans of more than nine years, is only 2.66 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 2.51 percent (assuming annual compounding).
As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.1 percent, while the rate for a 15-year loan was around 5.1 percent.
So, for a loan made in May 2022, you could take back a 30-year note that charges the long-term AFR of only 2.66 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 2.51 percent. Either arrangement would be a money-saving deal for your child.
In conclusion, we recommend to talk with a tax professional if you would like to discuss principal residence gain exclusion rules for any home sale and, especially, a sale of your home that has significantly appreciated.
If you have questions, don’t hesitate to contact me by scheduling a call, or by emailing at [email protected].
We specialize in helping clients clarify their taxes so they keep more of their money. Many small business owners who come to see us in Fort Worth, TX generally do not understand the tax law enough to explain it to a fifth grader.
Tatsiana B. Bender
Bender CPA, PLLC
Fort Worth, TX 76107
Phone: (817) 313-4352