The Capital Gains Tax on Selling Gifted Property
You could end up owing a gift tax or capital gains tax
People sometimes end up owning real estate and other property because the original owner has generously given it to them...but they don't particularly want it. They'd rather have the cash, so they decide to sell the gift.
Transfers of assets given before the original owner dies are gifts, not bequests, and there's a distinction between the two in the tax code. Recipients of gift property have different tax consequences than recipients of an inherited property if they decide to sell.
The Gift Tax If You Sell for Less Than Fair Market Value
The Internal Revenue Service does not consider gifts to be income, even if the gift is cash. Your wealthy grandmother can give you a million cold, hard dollars or artwork worth $1 million and you won't owe the IRS a single dime of income tax on it in either case.
You won't owe a gift tax, either—although your grandmother might and you would, too, if you decided to give the gift away or if you sold it for significantly less than its fair market value.
The recipient does not pay taxes or report income when a gifted asset is received, but the donor of the property must report it and possibly pay a gift tax subject to certain available exemptions and exclusions. The donor's generosity is taxable...to them. An annual exclusion and a lifetime exemption are both available to the donor, however, potentially erasing any tax burden.
As of tax year 2020, the gift tax annual exclusion remains at $15,000, the same as it was in 2019. The gift tax lifetime exemption increases to $11.58 million in 2020 from $11.4 million in 2019, but this exemption must be shared with the value of the donor's estate for estate tax purposes.
The Annual Exclusion and the Lifetime Exemption for Gifts
As of 2020, you can give away $15,000 per year in cash or property to any individual and this won't incur a gift tax. If you want to give more than that per person per year, you can either pay the gift tax in that tax year or you can "charge" it to your lifetime exemption.
The lifetime exemption is $11.58 million as of 2020. That's a lot of gifts. It's gradually reduced by each gift you give over $15,000 per person per year. Anything left over would protect your estate from paying an 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
If you sold your grandmother's artwork valued at $1 million for just $500,000, the IRS considers that you, therefore, gave a gift worth $500,000 to the buyer. That's $485,000 more than your annual exclusion, so you'd either have to pay the gift tax on that balance or subtract the $485,000 from your $11.58 million lifetime exemption that's available in 2020.
Applying the balance to your lifetime exemption would leave your estate with $485,000 less to protect itself against estate taxation at the time of your death.
That said, what happens if you decide to sell the gift at fair market value? Now you must report the capital gain or loss and you could possibly owe a capital gains tax if you realize a gain.
The Capital Gains Cost Basis of Gift Property
Capital gains or losses on property received as a gift during the donor's lifetime are calculated according to the original owner's cost basis in the asset. But if you were to inherit the property instead—the original owner decided to wait until his death to pass it on to you—its cost basis would be "stepped up" to the date of his death. This can make a big difference.
Otherwise, the 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 are depreciation that the previous owner might have claimed for renting out the property. This is passed to the new owner as well. The recipient's gain or loss on the gift would be the selling price minus this adjusted cost basis.
An Example of Cost Basis Before Death
Let's say your parent transfers his $300,000 house to you before his death. He paid $80,000 for it 30 years ago and made $40,000 worth of improvements to it over the years. He never claimed any depreciation on the property. Your cost basis is therefore $120,000—$80,000 plus $40,000. If you sell for $300,000, you've realized a $180,000 capital gain.
An Example of Cost Basis After Death
Now let's say your parent transfers his home to you as part of his estate plan after his death. The situation is much different because of that step-up in basis. If it's worth $300,000 at his death and you sell it for $300,000, there's no capital gain to be taxed. 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 Gift Property
The recipient also receives the donor's holding period in the property for determining whether a gain is long term or short term. If the donor held the asset for one year or less, it's a short-term gain. It's a long-term gain if it was held for longer than a year. An inheritance is always a long-term capital gain upon sale regardless of how long the donor owned it.
This 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. The rates for long-term gains are 0%, 15%, and 20% as of 2019, and they remain the same in 2020.
You wouldn't have to pay the 20% rate unless and until your top earned dollar hits the 37% ordinary income tax bracket. As of 2020, this works out to taxable income of:
- $518,400 for single taxpayers
- $622,050 for married taxpayers filing jointly and qualifying widow(er)s
- $518,400 for head of household filers
- $311,025 for married taxpayers who file separate returns
Most people fall into the 15% category.
The income limits that apply to each rate can change annually because they're adjusted for inflation.
Obviously, long-term gains are better than short-term gains. Suppose you're single and you earn $80,000 a year. You'd pay a 15% long-term capital gains tax, but you'd pay 22% if the gain was short-term and you were taxed according to your tax bracket. That's a significant 7% difference.
Recordkeeping Tips for Gift 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 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 sometimes the market value can come into play with gain or loss calculation. This can be as simple as arranging for an appraisal.
Tax Strategies for Gift Property
Consider living in the property for at least two of the five years before selling it if you receive real estate as a gift. This 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, and double that amount if you're married and file a joint return.
Exceptions to this rule exist for certain military members, and other rules apply as well.
Consider a Section 1031 exchange to defer the tax if the property is being rented out.
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