Gifting real estate can come with a few disadvantages from a tax perspective, depending on what the recipient does with the property. A capital gains tax can come into play.
Some tax professionals advise that people never 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 many considerations depending on how and when you're giving the gift.
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 use the valuation that results in the least possible estate tax consequences—the lesser the value, the better.
The goal is that the estate's entire value will be less than the year's federal estate tax exemption so no estate tax will be owed. Estates must pay the federal estate tax on values over $12,060,000 for deaths that occur in 2022, up from $11,700,000 in 2021.
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.
Your cost basis in the property as an heir 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 decide to sell the property after you inherit it.
The deceased probably paid much less for the property than its fair market value in the year of death if they owned the real estate for any length of time.
As an example, you'd have no capital gain if the decedent gave you real estate worth $350,000 as of the estate's valuation date and you immediately sold that property for $350,000. But you'd have a capital gain of $250,000 if you inherited the deceased's tax basis and they bought that property for $100,000 decades ago and gave it to you as an outright gift during their lifetime: the difference between the $100,000 basis and your sales price.
The greater the estate tax valuation, the less amount of 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 because there's no step-up in basis. Your cost basis would be $100,000, even if the property is now worth $350,000, if the deceased purchased the property for $100,000.
Review your "adjusted cost basis" in the property as well, because your cost 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
You'd pay a long-term capital gains tax on the difference between the cost basis and the sale amount if you owned the property for more than a year before selling and you earn more than $40,000 as a single taxpayer in tax year 2021 (or more than $41,675 in 2022). This threshold increases to $80,000 in 2021 (or $83,350 in 2022) if you're married and filing jointly, and to $54,100 in 2021 (or $55,800 in 2022) if you qualify as head of household.
Taxpayers will pay 15% in long-term capital gains tax if they exceed these income thresholds. In 2021, for instance, 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: $350,000 less your $100,000 basis ($250,000) times 15%.
At a certain very high income threshold, the long-term capital gains tax rate increases to 20%. This applies to single taxpayers with incomes of $441,450 or more as of 2021 (or over $459,750 in 2022), for married taxpayers filing joint returns with incomes of $501,600 or more in 2021 (or over $517,200 in 2022), or $473,750 for head of household filers in 2021 (or over $488,500 in 2022).
Short-Term Capital Gains Tax Rates
Most taxpayers are still better off long-term rates than the short-term capital gains tax rates. You have a short-term capital gain if you sell the real estate after you've owned it for one year or less. It's taxed at ordinary income rates according to your tax bracket in this case, which can be more than 20%.
The rate is 10% for single taxpayers with incomes up to $9,950 in 2021 (or up to $10,275 in 2022). These taxpayers would pay 0% in long-term capital gains tax.
The rate increases to 12% in the 2021 tax year if you're single and your overall income is $9,951 to $40,525 (or $10,275 to $41,775 in 2022). It increases to 22% on incomes of $40,526 to $86,375 in 2021 (or $41,775 to $89,075 in 2022), and it's 24% on incomes between $85,376 and $164,925 in 2021 (or $89,075 to $170,050 in 2022). You'd pay 32% on income from $164,926 to $208,425 in 2021 (or $170,050 to $215,950 in 2022), then the rate increases to 35% at income of $209,426 in 2021 (or over $215,950 in 2022). The top tax rate of 37% kicks in at incomes of $523,600 or more in 2021 (or over $539,900 in 2022).
These rates are for single taxpayers. Brackets for other filers are different, but follow similar patterns and hikes. And these income thresholds include all income—earned and unearned plus short-term capital gains.
It's obviously in your best interest to hang on to the property beyond the 12-month mark so you're eligible for the zero, 15%, or 20% long-term gains rate.
When Gifting Can Be a Good Thing
The loss of the stepped-up basis makes gifting during your lifetime a less favorable way of transferring assets, but it can still be an excellent strategy for shifting capital gains before the sale of a property to family members whose incomes are subject to lower tax rates.
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 before a potential sale.
What to Do?
You have a few options if you've already received property as a gift:
- 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 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 means 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, perhaps your child or another relative. Choose someone who wouldn't be subject to capital gains tax based on their income if they should sell. You might also give it to a charity, which can take all the gains tax-free and you'll get an itemized tax deduction besides, subject to certain rules.
Frequently Asked Questions (FAQs)
What IRS form do you use when paying taxes for a gifted property?
You will file IRS Form 709 to report gifts that trigger the gift tax.
What documents do you use when gifting property to children?
When you're giving property to family members as a gift, you can use a gift deed to transfer ownership.
What happens with title insurance when gifting property?
Gifting property does not release the borrower from their mortgage, and it may be difficult to get title insurance when gifting property. If the borrower does not make arrangements with the lender, then nothing will change with the mortgage, and the mortgage holder can only gift equity in the property rather than the property itself.