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 gift property face different tax consequences than recipients of inherited property if they decide to sell.
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 cold, hard 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 gift—although your grandmother might. You would only owe this tax if you decided to give the gift away, or if you sold it for significantly less than its fair market value.
The recipient doesn't 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 exemptions and exclusions. An annual exclusion and a lifetime exemption are both available to the donor, however, to potentially erase any tax burden.
The Annual Exclusion and the Lifetime Exemption
You can give away $15,000 per year in cash or property to any individual without incurring a gift tax as of 2020. 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 $11.58 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 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
The IRS considers that you would have given a gift worth $500,000 to the buyer if you sold your grandmother's artwork valued at $1 million for just $500,000. That's $485,000 more than your annual $15,000 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.
Applying the balance to your lifetime exemption would leave your estate with $485,000 less to protect it against paying an estate tax at the time of your death.
The Capital Gains Cost Basis of Gift 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 a capital gains tax if you realize a profit.
Capital gains or losses on gift 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—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 brokers' commissions.
Typical adjustments that reduce basis are 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 sales 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 sold it 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 Gift 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 would be a long-term gain if it were 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 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. As of 2020, ordinary tax rates range from 10% to 37% at the federal level.
The rates for long-term gains are 0%, 15%, and 20% depending on your taxable income. Most people fall into the 15% category.
Long-term gains are better than short-term gains taxwise. 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.
The income limits that apply to each tax rate can change each year because they're adjusted for inflation.
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 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 Gift 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.