Selling Gifted Real Estate Can Have Capital Gains Tax Consequences
The basis of gifted property can hurt you if you sell
Although it can be extremely generous, making a gift of real estate can come with a few disadvantages from a tax perspective, depending on what the recipient does with it. A capital gains tax can come into play when selling a gifted property.
Some tax professionals advise people never to give real estate. That might be a little extreme because there are some scenarios where it can be a smart tax move, but there are a lot of considerations regarding how and when you're giving the gift.
The Effect of Estate Taxes on Inherited Property
The executor of a decedent's estate will typically value all the property owned by the individual as of the date of death, then do so again six months later.
The executor can then choose whichever valuation results in the least possible estate tax consequences—the lesser the value, the better. The goal is that the entire estate's value will be less than that year's federal estate tax exemption so no estate tax is owed.
Estates must pay a federal estate tax on any value over $11.58 million for deaths that occur in 2020, up from $11.4 million in 2018. The majority of estates are never subject to this tax because the exemption is so high, but this could change if the exemption drops significantly, as it might when the Tax Cuts and Jobs Act expires after 2025.
Capital Gains Tax Considerations
It's generally better to receive real estate as an inheritance rather than as an outright gift because of capital gains implications.
As an heir, your cost basis in the property would be the fair market value of the real estate on the executor's chosen valuation date, not its initial purchase price when the decedent acquired it. This adjustment is called a "stepped-up basis" and it's an excellent way to minimize your capital gains tax liability if you later decide to sell the property.
If the deceased owned the real estate for any length of time, they probably paid much less for it than its fair market value in the year of death.
You'd have no capital gain if the deceased gives you real estate worth $350,000 on the estate's valuation date, and if you turn around and sell that property for $350,000. But you would inherit the deceased's tax basis if they bought that property for $100,000 decades ago and gave it to you as an outright gift during their lifetime. You would have capital gains in this case of $250,000.
The greater the estate tax valuation, the less profit will be subject to capital gains tax if you should decide to sell the real estate.
When Real Estate Is Given As a Gift
Your cost basis would be the same as the donor's cost basis if you received the property as a gift during the donor's lifetime. There's no step-up in basis. If they purchased the home for $100,000, that's your cost basis as well, even if the property is now worth $350,000.
Review your "adjusted cost basis" in the property as well in this case, because your basis can be reduced even more by any depreciation the donor might have claimed or could have claimed as tax deductions over the years.
Again, the lower your basis is, the greater your gain will be if and when you sell the home.
Long-Term Capital Gains Tax Rates
If you earn more than $40,000 as a single taxpayer in tax year 2020, you'll have to pay a long-term capital gains tax on the difference between the cost basis and the sale amount. This threshold increases to $80,000 if you're married and filing jointly, and to $53,600 if you qualify as head of household.
Long-term capital gains refer to property you've held or owned for more than a year. Taxpayers will pay 15% in long-term capital gains tax if they exceed these income thresholds. This could result in a capital gains tax bill of $37,500 if you sold that $100,000 property for its $350,000 current fair market value: $300,000 less your $100,000 basis ($250,000) times 15%.
It's even worse if you earn more than these thresholds. The long-term capital gains tax rate increases to 20% for single taxpayers with incomes of $441,450 or more as of 2020, for married taxpayers with incomes of $496,600 if they file joint returns, or $469,050 for head of household filers.
Short-Term Capital Gains Tax Rates
Most taxpayers are still better off than if they're subject to the short-term capital gains tax rates, however. If you hold onto the real estate for less than a year, this makes it a short-term capital gain when you sell, so it's taxed at ordinary income rates according to your tax bracket.
That's 10% for single taxpayers with incomes up to $9,875 in 2020. These taxpayers would pay 0% in long-term capital gains tax.
The rate increases to 12% as of the 2020 tax year if you're single and your overall income is $9,876 to $40,125, increasing to 22% on incomes of $40,126 up to $85,525. It's 24% on incomes from $85,256 up to $163,300, and 32% on incomes from $163,301 up to $207,350. Then it increases to 35% at incomes of $207,351, up until the top tax rate of 37% kicks in at incomes of $518,400 or more.
These rates are for single taxpayers. Brackets for other filers are different. And the income thresholds include all income—earned income and unearned income plus short-term capital gains.
It's obviously in your best interests to hang on to the property beyond the 12-month mark so you're eligible for that zero, 15% or 20% long-term gains rate.
When Gifting Can Be a Good Thing
The loss of the stepped-up basis makes gifting a less favorable way of transferring assets during your lifetime, but gifting can still be an excellent strategy for shifting capital gains to family members who have lower tax rates before the sale of a property.
That family member could earn up to $40,000 annually without paying any capital gains tax if they were single and held onto the property for more than a year. Gifting the property would be a way of choosing a more favorable tax rate on appreciated investments prior to a potential sale.
What to Do?
If you've already received property as a gift, you have a few options.
- You can simply keep the gift. You'll be on the hook for taxes if you sell the property, but the basis will step up for your own heirs if you hold onto it until you die. They can then sell it and shelter some of the capital gains.
- You can give the property back. The donor's cost basis would be the same as your cost basis, which is to say that it would be their original cost basis as adjusted for depreciation. They could then potentially leave the property to you as an inheritance instead.
- Finally, you can give the property to someone else. Choose someone, perhaps your child or another relative, who would not be subject to capital gains tax based on their income if they should sell. Or give it to a charity. A charity can take all the gains tax-free and you'll get an itemized tax deduction besides, subject to certain rules.
Tax laws change periodically and the above information might not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.
The Tax Foundation. "2020 Tax Brackets," Accessed Nov. 27, 2019.
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2020," Accessed Nov. 27, 2019.