Transfers of assets given before the original owner dies are gifts, not bequests, and the tax code makes a distinction between the two. People sometimes receive real estate or other property as a gift...but they don't particularly want it. They'd rather sell it and have the cash. Recipients of gifted property face different tax consequences from those of recipients of inherited property if they decide to sell.
- The IRS doesn't consider gifts to be income.
- The annual gift exclusion amount is $15,000 for tax year 2021 and $16,000 in tax year 2022.
- The lifetime gift exemption is $11.70 million in tax year 2021 and $12.06 million in tax year 2022.
- While gifts aren't taxed, the IRS may enforce a gift tax on any gifts you sell at less than fair market value.
If You Sell for Less Than Fair Market Value
The Internal Revenue Service (IRS) doesn't consider gifts to be income, even if the gift is cash. Your wealthy grandmother can give you a million dollars, and you won't owe the IRS a single dime. You won't owe the IRS a gift tax, either, if your grandmother gives you a non-cash gift. You will only owe this tax if you decide to give the gift away or if you sell it for significantly less than its fair market value.
The Annual Exclusion and the Lifetime Exemption
In tax year 2021, you could give away $15,000 per year in cash or property to any individual without incurring gift tax. The limit has gone up to $16,000 for 2022. If you want to give more than that per person per year, you have two options:
- You can pay the gift tax in that tax year.
- You can "charge" it to your lifetime exemption.
The lifetime exemption is $11.70 million for tax year 2021 and $12.06 million for 2022. The exemption gradually reduces by each gift you give over $15,000 per person per year in 2021 ($16,000 for 2022). Anything left over would protect your estate from paying the estate tax when you die, assuming your estate's value is equal to or less than the remaining lifetime exemption.
An Example of the Gift Tax
Say your grandmother is a famous artist and she gifts you a painting worth $1 million. You turn around and sell it for $500,000. The IRS considers that you would have given a gift worth $500,000 to the buyer since your grandmother's artwork was valued at $1 million. That's $485,000 more than your annual $15,000 exclusion, so you'd either have to pay gift tax on that balance or subtract the $485,000 from your $11.70 million lifetime exemption in 2021.
The Capital Gains Cost Basis of Gifted Property
What happens if you decide to sell the gift at fair market value instead? You must report the capital gain or loss, and you could owe capital gains tax if you realize a profit.
Capital gains or losses on gifted property received during the donor's lifetime are calculated according to the original owner's cost basis in the asset. But its cost basis would be "stepped up" to what it was worth on the date of their death if you were to inherit the property instead—that is, if the original owner decided to wait until their death to pass it to you.
This can make a big difference. The gift basis is what the original owner paid for the property, plus or minus any adjustments. Typical adjustments that increase basis are substantial repairs and improvements, along with any expenses incurred in the sale, such as broker's commissions.
Typical adjustments that reduce basis include depreciation that the previous owner might have claimed for renting out the property. This depreciation is passed to the new owner as well. The recipient's gain or loss on the gift would be the sale price minus this adjusted cost basis.
An Example of Cost Basis Before Death
Let's say that your parent transfers their $300,000 house to you before their death. They paid $80,000 for it 30 years ago and made $40,000 worth of improvements to it over the years. They never claimed any depreciation on the property. Your cost basis is therefore $120,000 ($80,000 plus $40,000). You'd realized a $180,000 capital gain if you were to sell the home for $300,000.
An Example of Cost Basis After Death
Now let's say your parent transfers their home to you as part of their estate plan after death. The situation is much different because of that step-up in basis. There's no capital gain to be taxed if the property's fair market value is $300,000 as of the date of death and you sell it for $300,000. You get $300,000 in either case, but in the second scenario, you won't have to give any of it to the IRS.
The Holding Period for Gifted Property
The recipient of the gift also receives the donor's holding period in the property for determining whether a gain is long-term or short-term. It's a short-term gain if the donor held the asset for one year or less. It's a long-term gain if they held the asset for longer than a year.
An inheritance will be taxed at the long-term capital gains rate upon sale, regardless of how long the donor owned it.
This holding period is an important distinction, because it determines the rate at which your capital gain is taxed. A short-term gain is taxed as ordinary income, according to your tax bracket. For tax years 2021 and 2022, ordinary federal tax rates range from 0% to 37%.
The rates for long-term gains are 0%, 15%, and 20% for 2021 and 2022, depending on your taxable income. Most people fall into the 15% category.
Long-term gains are more advantageous than short-term gains, tax-wise. Suppose you're single and earn $80,000 in tax year 2021. You'd pay a 15% long-term capital gains tax, but you'd pay 22% for every dollar in the 22% tax bracket if the gain were short-term, and you were taxed according to your tax bracket. That's a significant 7% difference.
The income limits that apply to each tax rate can change each year, because they're adjusted for inflation.
Recordkeeping Tips for Gifted Property
Ask the donor to provide you with the cost basis of the property and to let you know the date it was originally purchased. Try to obtain a copy of an escrow statement to document the amount and the date of the purchase.
You'll also want to get an estimate of the fair market value of the property on the date of the gift transfer, because market value can sometimes come into play with gain or loss calculations. This estimate can be as simple as arranging for a property appraisal.
Tax Strategies for Gifted Property
Consider living in the home for at least two of five years before selling it if you receive real estate as a gift. This period of residency can help make you eligible for a capital gains exclusion of up to $250,000 on the sale of a primary residence if you're single, or $500,000 if you're married and file a joint return. Other rules apply as well.
You might consider a Section 1031 exchange to defer the tax if the property is being rented out.
Frequently Asked Questions (FAQs)
How can a step-up in basis help reduce capital gains tax?
If you are inheriting a property, the person who is passing the property down to you can perform a step-up in basis adjustment in which they pay the difference between the value when it was originally purchased and its worth at the time of adjustment. This can greatly reduce the inheritor's tax liability.
How can you reduce the cost of capital gains tax when selling a gifted house?
If you have been gifted a home, consider living in it as your primary residence to help you reduce the capital gains taxes that apply to the home's sale. This is referred to as the 2-out-of-5 rule, but be aware of rule exceptions if you are hoping to use it in the future.