Getting a Real Estate Gift Could Have Tax Consequences
The Basis of Gifted Property Can Hurt You at Tax Time
It can be immensely generous, but making a gift of real estate often comes with several disadvantages from a tax perspective. Some tax professionals advise people never to give real estate. That might be a little extreme because there are some isolated scenarios where giving real estate can be a smart tax move, but there are a lot of considerations.
Capital Gains on Inheritances
It's generally better to receive real estate as an inheritance rather than as a gift.
The executor of the decedent's estate will value all the property he owned as of the date of his death. The executor will also usually value all the property again six months after the date of death. The executor can then choose whichever valuation date results in the least possible estate tax consequences—the lesser the value, the better.
As an heir, your cost basis in the property would be the fair market value of the property on the chosen valuation date, not its initial purchase price. This 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 he owned the property for any length of time, he probably paid much less for it than its fair market value in the year of his death. The greater the valuation, the less "profit" is subject to capital gains tax should you sell the property.
Capital Gains on Gifts
Your cost basis would be the same as the donor's cost basis if you received the property as a gift during his lifetime. There's no stepped-up basis. If he purchased the property for $65,000, that's your cost basis as well, even if the property is now worth $200,000.
You should review your "adjusted cost basis" in the property as well, because your basis can be reduced even more by any depreciation the donor claimed or could have claimed as tax deductions.
Again, the lower your basis is, the greater your gain will be if and when you sell the property. If you earn more than $38,600 as a single taxpayer as of 2018, you'll have to pay a capital gains tax on that difference. This threshold increases to $77,200 if you're married and filing jointly, and to $51,700 if you qualify as head of household. Beyond this, most taxpayers will pay 15 percent on long-term capital gains on property they held or owned for more than a year. If you sold that $65,000 property for its $200,000 fair market value, it could result in a capital gains tax bill of more than $20,000.
Short-Term Capital Gains
What happens if you hold onto the property for less than a year? That makes it a short-term capital gain taxed at ordinary income rates according to your tax bracket. That's 12 percent as of the 2018 tax year if you're single and your overall income is $38,700 or less, increasing to 22 percent on incomes of up to $82,500. It's 24 percent on incomes of up to $157,500, 32 percent on incomes of up to $200,000, and 35 percent on incomes of up to $500,000. Then the top tax rate of 37 percent kicks in.
It's obviously in your best interests to hang on to the property beyond the 12-month benchmark if possible so you're eligible for that zero or 15 percent 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, but gifting can be an excellent strategy for shifting capital gains to family members who have lower tax rates. That family member could earn up to $38,600 annually without paying capital gains tax if she were single. 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 if you hold it until you die, the basis will step up and your heirs can 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 is his original cost basis as adjusted for depreciation and other factors which transferred to you when he gave it to you. He could then potentially leave the property to you as an inheritance.
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 his income if he should sell it. Or give it to a charity. A charity can take all the gains tax-free.