Receiving a Gift of Real Estate Can Have 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 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 it can be a smart tax move, but there are a lot of considerations.
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.
The executor of the decedent's estate will value all the property he owned as of the date of his death. She'll also usually it again six months later. She can then choose whichever valuation 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 the deceased 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 will be subject to capital gains tax if you should decide to sell the property.
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 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.
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 over the years.
Again, the lower your basis is, the greater your gain will be if and when you sell the property. If you earn more than $39,375 as a single taxpayer as of 2019, you'll have to pay a capital gains tax on that difference. This threshold increases to $78,750 if you're married and filing jointly, and to $52,750 if you qualify as head of household.
Taxpayers will pay 15 percent in long-term capital gains tax on property they held or owned for more than a year if they meet these income thresholds. This could result in a capital gains tax bill of $20,250 if you sold that $65,000 property for its $200,000 current fair market value: $200,000 less your $65,000 basis times 15 percent.
It's even worse if you earn more than these thresholds. The long-term capital gains tax rate increases to 20 percent for single taxpayers with incomes of $434,550 or more, married taxpayers with incomes of $488,850 if they file joint returns, or $461,700 for head of household filers.
Most of these taxpayers are still better off than if they're subject to the short-term capital gains tax rates, however.
Short-Term Capital Gains
What happens if you hold onto the property for less than a year? This makes it a short-term capital gain taxed at ordinary income rates according to your tax bracket.
That's 10 percent for single taxpayers with incomes up to $9,700 in 2019. These taxpayers would pay zero percent in long-term capital gains tax.
The rate increases to 12 percent as of the 2019 tax year if you're single and your overall income is $9,701 to $39,475, increasing to 22 percent on incomes of $39,476 up to $84,200. It's 24 percent on incomes from $84,201 up to $161,725, and 32 percent on incomes from $161,726 up to $204,100. Then it increases to 35 percent at incomes of $204,101, up until the top tax rate of 37 percent kicks in at incomes of $510,300 or more.
It's obviously in your best interests to hang on to the property beyond the 12-month benchmark so you're eligible for that zero, 15, or 20 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 still be an excellent strategy for shifting capital gains to family members who have lower tax rates.
That family member could earn up to $39,375 annually without paying capital gains tax if she 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 if you hold onto it until you die, the basis will step up. Your heirs can then sell it and shelter some of the capital gains.
Or 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 his original cost basis as adjusted for depreciation. He could then potentially leave the property to you as an inheritance.
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 his income if he 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.