Selling the house to your child in exchange for a hug and a smile? Expect to raise a few eyebrows at the IRS with that generous freebie—Uncle Sam doesn’t let taxes slide in the name of nepotism.
As much as you’d like to hand over the keys and keep financials between family, you’ll need to treat the transfer as a smart business deal or risk increasing your tax liability.
The devil’s in the details, but you’ve got options:
- Let your child inherit the house.
- Gift the house outright.
- Finance your child’s purchase of the house.
- Sell the house to your child at a discount.
- Sell the house to your child but continue to live there.
- Let your child assume the mortgage.
- Use a personal trust.
With the help of accounting expert A.J. Gross, CPA, E.A, and Founder and President of ALG Tax Solutions, let’s go through each option and its tax implications (with dummy-proof examples) per 2018-2019 IRS rules.
If you’re still stuck in the end—we’ve also highlighted at the bottom what we think is (in many cases) the best route for a smooth transfer of the family house from one generation to another.
So, keep reading, and happy house-giving!
Option 1: Let your child inherit the house
If you live in your house until your final moments, your surviving relatives can inherit the contents of your estate (everything you own minus your debts). This means, when you die, you can pass your house on to your child if you wish to, as expressed through a valid will.
When you transfer property after death, however, the government levies an estate tax, and your child will only receive the house after those taxes have been taken out of your estate.
However, there is an exemption called the Unified Federal Gift and Estate Tax Exemption, which, in 2018, gives each person an $11,180,000 exemption (approx. $22.4 million for married couples) to exclude from their taxable estate.
You’re only taxed on what remains after the exemption (see: gift/estate tax rates). So, if your estate is worth less than $11.18 million—as it is with most individuals—you can pass on your house to your child, tax free, as part of your estate plan.
On top of that, your child can potentially escape capital gains taxes when they decide to sell the house down the line. The capital gains tax is the tax imposed on the sale of a capital investment such as a house, but most people qualify for the personal residence exclusion—up to $250,000 for single filers and $500,000 for married couples.
If your child inherits your house, the stepped-up basis rule comes into effect. When you die, the cost (or basis) of your house is “stepped up” to the market value of your house on the date of your death.
If you bought your house for $200,000, its basis will be $200,000 the entire time you live in it. But, on the day you die, if your house was worth $500,000, its basis is “stepped up” to $500,000 and is no longer $200,000. So, if your child decides to later sell the house for $550,000, the profit on the sale is only $50,000 ($550,000-$500,000), not $350,000 ($550,000-$200,000).
Your child takes home $550,000 in either scenario. But in the eyes of the government, you can use the stepped-up basis to show a profit of only $50,000 vs. a profit of $350,000.
This has a real impact on the amount of capital gains your child has to pay: less theoretical profit = less taxes.
Even better, if your child sells the house after living in it for 2 years, they can qualify for the homeowner’s capital gains exclusion, which might eliminate taxes owed as a whole!
Option 2: Gift the house outright.
What if you don’t want to live in your house until you die?
If your dream is to leave the empty nest behind but keep the house within the family, another option you could explore is gifting the house to your child. This is a popular option but comes with some caveats.
IRS rules say the giver of a gift must pay taxes on that gift. The recipient doesn’t. So, if you gift your house to our child, you have to pay gift taxes (which range from 18%-40%) on the value of the house.
It is per-person and per-recipient, so if you and your spouse are both gifting your house to your child, you can double that exclusion amount, and gift $30,000 tax-free. Gross says this exclusion amount “can even go up to $60,000 if married parents are gifting a house to their married child and spouse.”
Say your house is worth $200,000. You’re married, and your child is also married. You and your husband can give your child and their spouse $15,000 each, and they can exclude up to $60,000 ($15,000 x 4) as part of the Gift-Tax Exclusion. You will only have to pay taxes on the remaining $140,000.
At this point, you have two more options. You can either pay gift taxes on the $140,000, or the IRS will let you subtract it from your lifetime Unified Federal Gift and Estate Tax Exemption of $11,180,000.
Most people subtract the gift from their lifetime exemption amount… who wants to pay more taxes? The gift tax rate is a hefty 40% at its highest, so this is your best option.
Simply file a Gift Tax Return (Form 709) along with your Individual Tax Return (Form 1040) in the year you are making the gift. You won’t have to pay gift taxes, but the Gift Tax Return will help keep track of your gifts every year.
Unfortunately, if your estate is greater than $11.18 million, you will end up paying gift taxes, depending on the amount of your Taxable Estate > $11.18 million. Check out the Tax Foundation’s guide on State Estate and Inheritance taxes if you’re in this situation!
Remember these two things about the outright gift option, though:
- There is no stepped-up basis when you gift your house.
Carryover basis applies here instead. The cost of the house when your child sells it later on will be the lower price you paid for it (your basis “carried over” to your child). From the example in Option 1, this means your child’s profit when they sell will be $350,000, not $50,000. And then it’s a numbers game from here. If the homeowner’s exclusion covers the entire profit, then no worries! If not, your child will most likely be paying a capital gains tax.
- You are eating away at your Estate Tax Exemption.
The Estate Tax Exemption is a lifetime exemption amount that gets smaller every time you use it. Note, however, that the estate tax exemption was raised more than double over 2017’s $5.49 million exemption per person to the 2018 rate of $11.18 million. Most people’s estate’s will fall under $11.18 million.
Option 3: Finance your child’s purchase of the house.
Let’s take a quick detour here. Options 1 and 2 are for parents who are feeling particularly generous towards their children. Say you don’t want to gift your house to your child, or maybe you need the money from the sale. In that case, there are a few different routes you can take.
A solid option is to sell your house at its full fair market value (FMV) to your child. This is a great choice if your child is well-settled and wants to earn the house in an affordable way.
Instead of demanding the full price of the house at the time of sale, consider making an installment sale for the full price.
It works like this:
Say your house is worth $500,000 (determined by a home appraisal). If your child can afford to pay a down payment of 10%, or $50,000, create a note for the remaining $450,000. Make sure the note is written, and that you’ve explicitly expressed the monthly payments your child has to make to you.
Gross stresses that you need to charge at least the applicable federal rate (AFR) aka the market rate on the loan, which is ~3% as of March 2019.
As long as the note is legally secured to the house, every month when your child makes principal and interest payments on the note, they can deduct the interest payments as qualified mortgage interest (however you will still have to pay taxes on that interest income).
You can also provide your child additional help by still making annual gifts of $15,000 maximum under the Annual Gift-Tax Exclusion. But make sure that the two streams (gifts and note) are separate. If you forgive a note payment in lieu of a gift, the IRS might think the entire sale is a discount sale (see Option 4).
Option 4: Sell the house to your child at a discount.
What if your child is not in a financial position to afford your house at full price? Unfortunately, this is not an advantageous situation for you as a parent.
If you sell your house to a perfect stranger for less than its FMV, then you can take a loss. It was a bad sale, but the IRS doesn’t care because it’s an arms-length deal.
But if you try to sell your house to a relative, aka your child, for less than its FMV, the IRS considers this a gift, and won’t simply let you take a loss on the sale. This is a related-party sale, and you will either have to use your Annual Gift-Tax Exclusion and a large amount of your Estate Tax Exemption to offset the sale, or pay gift taxes if you choose not to whittle away your exemption.
Your child’s basis in the house is also lower—the lower sale price will become their basis for any future sales and could result in higher capital gains taxes down the road.
Say you want to sell your house to your child for $1. You think it’s a smart deal, but really, it puts everyone at a disadvantage. According to Gross, “If the FMV of your house is $500,000, and you sell your house for $1, you are essentially giving your child a $499,999 gift.”
You can exclude from taxes up to $30,000 of this gift (if you’re married) under the Gift-Tax Exclusion. This leaves $469,000 that you now either have to pay gift tax on or must exclude from your Estate Tax Exemption of $11.18 million.
As we mentioned earlier, your Estate Tax Exemption can probably take a one-time hit since it is so high this year. But keep doing this with the next house, and the next, you’re going to have no Exemption left to exclude your final estate when you really need it. Remember, as of now, the $11.18 million is only until 2025.
Option 5: Sell the house to your child but continue to live there.
One of the more complex situations you can face is if you want to transfer your house to your child’s name, but also want to continue living in it as if nothing changed.
Maybe your child is working in a different state, or is still in college, and you want essentially a transfer in name only.
Well, you can’t just change the name on a deed without repercussions down the road (see Option 6 below).
So your options are:
- Do sell your house to your child at FMV (Option 3) and then pay rent to live in now their house. This is a perfectly acceptable arms-length deal if the sale and rent are at market rates—you’re paying fairly for the “use and occupancy” of the home. Your child could even claim various rental property deductions.
- Don’t sell your house to your child at less than FMV (Option 4) and then pay less than market-level rent afterwards. This is not considered a true sale, because according to Section 2036(a)(1), the IRS thinks you never gave up “possession and enjoyment” of the home. The consequence here is that the full FMV of your home will be included in your estate and taxed when you die, and your child can’t take any rental deductions either.
Option 6: Let your child assume your mortgage.
In general, if you want to give your house to someone, the transfer is done through the signing of a deed.
Typically, if you are selling your house to a third party stranger, you would sign a “warranty deed.” This promises that the seller actually owns the property, has the right to sell it, and has no liens or mortgages on it.
If you are transferring ownership of your house to your child (a non-traditional sale), you would use a “quitclaim deed” instead. This allows you to transfer title but makes no promises about anything else. A stranger would want more guarantees, but your child may not.
A lot of folks assume they can simply sign and notarize a quitclaim deed, file it with the county clerk, and the house transfers over. There are two problems with this:
- Because there is no transfer of money when you sign a quitclaim deed, the IRS considers this a gift, and applies gift tax rules (Option 2 above).Since quitclaiming is easy, Gross reports that sometimes parents will quitclaim their house to their child, without tax consultation, and won’t report it to the IRS. This leads to problems later on, when the child tries to sell the house.The parent has likely died, and the basis of the house at the time of transfer is unknown, which leads to complex tax estimation calculations based on approximate figures. This is unfavorable in practice.
- A quitclaim deed only transfers ownership of your house, not any mortgages or loans associated with the house.
The mortgage is still in your name, and you would still have to pay it. Even worse, most mortgages have a due-on-sale clause, where you have to immediately pay the mortgage in full if you transfer ownership of your house.
So, you have a few choices here.
First, you can pay off your mortgage and transfer your house free and clear (Option 3 above).
Second, you can ask if your bank will let your child take over your mortgage. Not all banks allow mortgage assumption and not all mortgages are eligible (only FHA, VA, and USDA are eligible). You would sell your house at a price equal to the mortgage balance, and your child would need to be creditworthy and meet the bank’s lending criteria. According to Gross, even a mortgage assumption could be considered a gift depending on how much of the mortgage is left over, so clarify with your accountant before you do this.
And third, you can check with your mortgage lender to refinance your existing mortgage and add your child to your home’s title, making them co-owner.
These are complicated transactions, so make sure you check with your bank or mortgage lender as well as your accountant before entering one.
Option 7: Use a personal trust.
Lastly, you have the option of using a Qualified Personal Residence Trust (QPRT) to pass on your house to your child.
A QPRT is a type of irrevocable trust and is a great way of passing your house onto your child while still being able to live in it. Here’s how it works:
With the help of your accountant, you first create a QPRT and transfer your house into the QPRT. You name the beneficiaries of the trust (in this case, your child/children), and then you set a trust term limit (a specific number of years after which the property in the QPRT will pass on to your beneficiaries).
The house remains under your name, you still make your mortgage payments, and you’re still allowed to live in the house until the end of the trust term limit. After the term ends, the house transfers to your child’s name, and you have to pay your child rent if you want to continue living in the house.
Now, let’s look at the tax implications of this option.
When you transfer property into the QPRT, it is treated like a taxable gift by the IRS. In the eyes of the government, transferring your house into the trust is the same as gifting your house to your child, so you have to either pay gift taxes or deduct the value of your house from your estate tax exemption.
The benefit of using the QPRT though, is that you can transfer your house into the trust at a lower value than what it is actually worth. Since you’ll be living in the house for many years before it is actually transferred to your child, the IRS lets you account for that decrease in value today.
Say the FMV of your house is $1 million today, and you create a QPRT, naming your son as the beneficiary. There are some complex calculations that take place behind the scene, that take into consideration how old you are, the term limit of the trust, interest rates, and a few other things.
After all the calculations, if we assume your house is only valued at $350,000, the gift taxes/estate tax exemption only applies to the $350,000 not the entire $1 million. This is a huge difference from normal gift taxation, as you have essentially transferred an asset worth $1 million for just $350,000, saving $650,000 of your estate tax exemption.
One thing to remember—you must live longer than the trust term. If you create a QPRT today, and set the term limit as 15 years, but you die in 13 years, the entire value of the house on the date of the transfer ($1 million from the example above) gets included in your estate and is subject to estate taxes when you die. Essentially, it’s like the trust never happened.
But, if you outlive your trust term, when your child gets ownership of the house, the value of the house will be your initial purchase price (just like regular gift tax rules in Option 2), and they get to take advantage of not paying any estate taxes.
Make sure you file a Gift Tax Return (Form 709) in the year you make the gift to the QPRT, and you are good to go!
TL;DR, this option may not be worth it unless you are ultra-rich. With the estate tax exemption being $11.18 million this year, unless your assets come close to that, you might as well just use your estate tax exemption for each gift you make.
What’s your best option? Top accounting experts say…
The BEST option, according to Gross, the accounting expert, is Option 5—sell your house at FMV and finance your child’s purchase of your house. After a few years, the house will be passed on to your child, it doesn’t affect your estate, and it’s tax-free for your child. It leaves all parties in the most favorable position.
However, tax decisions are not black and white, and it really comes down to what works best for you individually. At the end of the day, Gross says, the accountants are “there to explain the rules, answer questions, and guide the client based on their goals, but not make any decisions.” That’s your job, as a homeowner.
On one hand, Option 5 might work best for someone who is highly organized and able to keep track of their tax documents, loan documents, gift-tax filings, etc. year after year until the property is fully transferred to their child. As Gross says, “The more documentation you have to justify your intent, the better your chances are in case you get audited.”
On the other hand, for someone who is extremely busy and is unable to spend the time tracking the entire transfer, Gross recommends Option 2—gifting the house outright. It is a one-time deal, with less complications.
Any one of the other options above might work for you, too, depending on your situation, so read through them carefully, and consult an tax professional as necessary.
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