Dear Tax Guy,
I am a 42-year-old father of a son and daughter. I have a paid-off investment property in Oklahoma that was my first home and where I raised my daughter. I bought the property for $120,000 and it is currently valued at $210,000 and my daughter says that she wants this home to be her first home.
I have always had every intention of leaving this home to her when I pass, but if she wants the home sooner I don’t know how to give her ownership of the property without selling it to her. However, selling would result in a very large capital-gains tax, and I really don’t want to be a landlord at the risk of letting money come in between our relationship.
I want her to have this home as it was a great starter home for me when I purchased it, but I don’t know how it makes sense financially. What would be the best way to pass this home to my daughter so that I can avoid the large tax bill and avoid having to be a landlord to her? I appreciate your expertise.
Fortysomething Dad
Dear Fortysomething,
You are correct, selling your home may not be the most optimal way to go about doing this transfer. As you noted, since this is an investment property, selling the house will result in the gain being taxed at capital-gains rate, which could be even at a higher rate due to depreciation recapture (if the property was rented previously). You have a few options available:
Leave it to your daughter in your will
The easiest way is to leave the house to your daughter as part of your will. When your daughter inherits the house, the tax basis gets a “step up” which essentially means that the basis would be the value of property at the time of death. This will eliminate or lower any capital-gains taxes that would be owed when the property is sold. The federal estate tax lifetime exemption amount for 2024 is $13.61 million. So as long as your total estate is below this amount you should not owe any estate taxes.
Oklahoma currently has no estate tax so you are good there. If you don’t want to charge her rent, the fair market value (FMV) of any foregone rent would be considered a gift. But as long as the FMV of rent payments is less than $18,000 (the annual gift exclusion amount for 2024) you don’t have to worry about any gift tax issues or filing requirements.
Any excess will reduce your lifetime exemption amount noted earlier and you would be required to file a gift tax return. This option may be easiest but does not transfer ownership to your daughter now.
Gift the house to your daughter
A second option is to give your house to your daughter now as a gift. Based on the above facts you will not owe any gift tax as long as your gift in total is less than $13.61 million (for 2024). You should get an appraisal on the house and file a gift-tax return to report the gift.
You don’t have to worry about rent payments etc., since your daughter owns the house. Your daughter should be responsible for paying real-estate taxes and all future maintenance on the property.
Note that in this case, your daughter will not receive a step-up in basis in the house but this could be offset by the availability for her to exclude $250,000 (or $500,000 if she is married) of any gain if this is her principal residence for at least two out of five years prior to the sale
Create an irrevocable trust
Finally, you could transfer the property into an irrevocable trust that has your daughter as the sole beneficiary. The upside of doing this is that this will provide asset protection and the house will not be subject to creditors or divorce. In addition, you get all future appreciation out of your estate.
The terms of the trust can dictate if and when the house is distributed to your daughter (either upon your death or in the discretion of the trustee). In either case, since the house is held in trust, it can pass directly to your daughter bypassing probate court. As a beneficiary of the trust, your daughter can live there without paying rent.
But there should also be an arrangement that she pays for monthly maintenance; otherwise, if it was paid by you, this would be an additional gift. The downside is that if the house is sold within the trust, it is not eligible to exclude any of the gain on the sale of the principal residence since it was not owned by her.
Note you will have a gift tax return (Form 709) filing requirement when you put the house in a trust or make a gift that exceeds the annual exclusion amount ($18,000 for 2024).
You can decide which option suits your and your daughter’s needs.
Varun Vig is partner at Eisner Advisory Group LLC in New York City.
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