“If I buy the house from her at fair market value, what happens?” (Photo subject is a model.) – Getty Images/iStockphoto
If my mother sells or gifts me her $800,000 personal residence to me, my understanding is that I also get her adjusted cost basis. If she holds a note for 100% of the purchase price and then gifts me the note, will I end up with current fair market value as my cost basis?
As a result, she would have no income-tax consequence — right? — because her original cost basis and her recently deceased spouse’s stepped-up cost basis, plus their combined personal-residence exclusion, more than covers the fair market value.
Is this gift a good tax strategy or a sham transaction?
Use a trusted real-estate attorney and proceed with care. – MarketWatch illustration
It’s more complicated than that. If your mother gifts you the property today, you would be well within the lifetime gift-tax exclusion of $13.99 million, and far above the annual gift-tax exclusion of $19,000 so you would have to file a gift tax return (Form 709). However, you will lose your step-up in basis if/when you decide to sell.
“When you make a gift transaction, for income tax purposes, the child will assume your tax basis in the property,” says Quatrini Law. “This can become an important tax issue down the road. Your child could therefore expend thousands of dollars in capital gain tax that potentially could have been avoided had you simply kept the property in your name.”
If your mother purchased the home for $100,000 and it’s now worth $800,000, gifting the home to you assumes that the tax basis in the property is $100,000, not $800,000 and/or the value at the time of your mother’s passing. That would increase the amount you would have to pay in capital-gains tax at a sale by at least tens of thousands of dollars.
There are other options. Your mother could sell the property to you and hold the note/loan agreement for the balance of the purchase price. If her house is worth $800,000 and you decide to give $100,000 as a down payment, she holds the note for $700,000. This would mean you still get your step-up in basis.
If, on the other hand, you purchase the house from your mother at fair market value and she holds a note for 100% of the purchase price and subsequently forgives the note a later year, you will end up with the current fair-market value as your cost basis, says Pamela Dennett, partner, private client services, at Eisner Advisory Group.
Forgiving a note is typically treated as a gift. “The general rule is that the basis of property received as a gift is the same as the basis in the hands of the donor,” Dennett says. “However, in this scenario, you are purchasing the property at fair market value, which establishes your cost basis at the purchase price.”
Therefore, the subsequent gift of the note, in a later year, would not affect the tax basis of the purchased property, she adds. “Your mother would have no income-tax consequence from the sale of the house if the combined adjusted cost basis (including the stepped-up basis from her recently deceased spouse) and the personal-residence exclusion cover the fair market value.”
Under Section 1014 of the U.S. tax code, the cost basis of property acquired from your mother would be the fair market value at the date of her death. Existing law allows for single filers to exclude $250,000 in capital-gains tax, which doubles to $500,000 for joint filers. That amount, established in 1997, has not changed in 26 years.
Therefore, if the combined basis and the exclusion exceed the fair market value, there would be no taxable gain on the sale, and thus no income-tax consequence for your mother, Dennett says. She would have to file a U.S. gift-tax return in the year she forgives the note and, assuming she has not yet reached her lifetime gift exclusion, she would not owe gift tax to the IRS.
Proceed with care. I’ve received many letters from readers who purchased a home from their parents only to find themselves in a sticky situation. This reader wrote to say he bought his parents’ home and put his brother on the deed, and his brother is now holding the entire family “hostage” and won’t pay the mortgage.
Another woman wrote to me earlier this year to say she’d purchased a home for and (this is the sticky part) with her parents, and paid the legal costs and the down payment, with the agreement that they would sell their home and repay her their share for the new home. Surprise, surprise! The parents reneged on the deal. Even parents can pull a fast one on their own kids.
Family drama aside, your plan sounds like a solid one from a tax perspective.
