Often, those with large real estate portfolios wonder what to do with their assets when estate planning. In this instance, it's very common to think about gifting real estate. However, doing so can have significant tax consequences. With that in mind, let's explore the tax implications you and your loved ones might face as well as the best methods for gifting real estate while still enjoying tax savings.
The tax consequences of gifting real estate
Before you give a real estate gift, it's important to consider how the gift will be treated for tax purposes. Unfortunately, if you don't plan appropriately, your beneficiary can end up with a pretty hefty tax bill at the end of the day. With that in mind, below is a closer look at the potential tax consequence of gifted property. Read over each factor to get a better idea of the impact your gift will have on both of your tax returns.
The gift tax
First up is the federal gift tax. If you haven't heard of the gift tax before, it's important to note that anytime an asset is given to someone else without money changing hands, it's considered a gift in the eyes of the IRS. As of 2021, each U.S. citizen or permanent resident has a lifetime gift tax exemption of $11.7 million, which means that each person can give away up to that amount in their lifetime or pass it on after their death. However, any assets given away above that amount will be subject to the gift tax.
Additionally, each person gets an annual gift tax exemption of $15,000. However, since gifted property will exceed the annual gift tax exemption in most cases, the donor must be sure to submit a gift tax return, which claims an amount exceeding the annual exemption toward their lifetime gift tax exemption.
Capital gains tax
Unfortunately, a real estate gift can also have substantial capital gains tax implications, depending on the way it's gifted and the amount of appreciation that's occurred. Typically, when an asset is gifted from one party to another, the recipient takes on the donor's cost basis, which represents the price at which the donor originally acquired the asset. In this instance, if the recipient sells the asset, any capital gain or loss would be calculated based on the donor's original cost basis.
However, if an asset is given as part of an inheritance, the beneficiary gets what's known as a "step-up in cost basis." Here, the adjusted basis will be worth the fair market value of the asset at the time of the previous owner's death. Then, if the beneficiary decides to sell the asset, any capital gain or loss will be calculated based on the adjusted basis.
Therefore, if you have a valuable asset that's likely to be sold, it's much better to give it as an inheritance than an outright gift so your beneficiaries can take advantage of the tax benefit of the adjusted tax basis.
Finally, it's also important to note that gifting a large asset like real estate can have an impact on your Medicaid eligibility if you need long-term care in your later years. Put simply, Medicaid is a means-tested program, meaning you need to be at poverty level to qualify.
The program's evaluation methods include a financial audit for the five years prior to the application date. Specifically, Medicaid will look for any gifts given during that five-year window. If you've given a gift during that time, acceptance of your application may be delayed.
What's the best way to give real estate to a friend or family member?
Given those tax implications, many people wonder what's the best way to give real estate to their loved ones and to enjoy some tax savings. To that end, we've laid out a few common scenarios for you below. Take a look at each to get a sense of which method of gift planning may be the best fit for you.
Own the property as joint tenants with right of sole survivorship
Often, parents will seek to protect their primary residence by adding their child to the deed while they're still living. If you're going to go this route, there are two things to consider. First, you need to know how you all intend to be listed on the deed.
In this case, you'll want to make sure you're listed as joint tenants with the right of survivorship. With that kind of ownership interest, you can be sure the property will pass directly to your heirs. if you're listed as tenants-in-common instead, that does not necessarily have to be the case.
That said, if achieving tax savings is your main goal, you may not want to go this route. Put simply, the IRS considers this type of transfer a taxable gift, meaning that if your heirs decide to sell the home, they'll have to do so at your original cost basis.
Pass on the property in your will
In the event that your estate is worth less than the lifetime exemption for the gift tax, you can simply pass on the property in your will as part of your estate plan. Here, the transfer of property will be considered inheritance rather than an outright gift, so if your children decide to sell the property, they'll be able to do so at an adjusted basis for the current fair market value of the property.
Put the properties in a trust
If, while doing your estate planning, it looks as though your taxable estate will be worth more than the lifetime exemption, your best bet is to put the properties in a trust. In this case, you would simply title the property in the name of the trust and then name your children or other family members as trust beneficiaries.
In the event that you wanted to continue to be able to live in your primary residence and still avoid the estate tax, you would want to form a qualified personal property trust instead. This type of trust works in much the same way, except that it also gives you the right to live in the property for a certain number of years.
Three alternative methods of gifting real estate
In the event that you don't want to give the gift of real estate to a friend or family member, there are still plenty of ways to help your life estate avoid probate. We've listed three of the most viable ones below.
Donate a conservation easement
If you donate a conservation easement to a qualified land trust, you can save big on federal, and potentially state and local taxes, especially thanks to a 2015 boost by Congress.
If you're a farmer or rancher, the IRS allows you to deduct 100% of your annual income for 16 years while other donors can deduct 50% as a charitable contribution for the easement.
A land conservation easement must be donated to a qualified land trust. It is a legally, permanent, and enforceable agreement between the property owner and the easement holder that it will serve certain conservation purposes. Property owners retain most rights, except to develop or further improve the property.
Say you own five acres of land and you want to donate three of them to a land trust that will ensure the land cannot become a subdivision. The development value of that land is $1 million, and its value with the easement is now $500,000. The value of the easement is then $500,000, and your income is $100,000 per year. If you're a farmer or rancher, you essentially won't pay federal and sometimes state income taxes on your income for five years, until the value of the easement is realized.
Some states, such as Maryland, offer even sweeter deals. If you donate a conservation easement to the Maryland Environmental Trust or the Maryland Agricultural Land Preservation Foundation, you also get up to $80,000 in state income tax credits as well as property tax credits for 15 years. The property has to meet certain criteria to be accepted.
New York state offers property owners a rebate of 25% of property taxes up to $5,000 annually when land is donated to a government agency or the Hudson Highlands Land Trust.
Give the property as a charitable gift
If you were to sell your property, you would have to pay capital gains taxes on its appreciation after your cost basis. So rather than sell your property and gift the proceeds to charity, you should gift and deduct the property at the fair market value. That's because a qualified charity or nonprofit would not have to pay taxes, netting the beneficiary more and saving you the taxes.
You can deduct the property's fair market value as of the date of the transfer, but there are some stipulations and factors for how to determine what that is. You should have a qualified appraisal, sales comparables, replacement cost data, or other expert opinions to back up your claim. The income tax deduction immediately applies in the year in which the contribution was made, and you can carry forward the amount for five years. The deduction is limited to 50% of your adjusted gross income (AGI) for cash gifts and 30% of AGI for appreciated securities and real estate. This can be extra beneficial if you've received a windfall that year, such as an inheritance or proceeds from the sale of a business.
The organization you gift it to must meet the criteria of section 170(c) of the Internal Revenue Code.
In addition to the charitable contribution deduction, which is not currently capped at the federal level, you may be eligible for tax incentives in certain states, such as Maryland's Community Investment Tax Credit, which allows you to claim a credit of up to half the fair market value of real property to preapproved organizations, up to a $250,000 limit.
North Dakota residents can receive a 40% income tax credit on the value of property donated to the University of North Dakota Foundation (there's a minimum of $5,000 annually), and individual businesses can carry forward unused credits for three years.
Talk to a financial advisor in your state to see what specific opportunities may be available for charitable deduction.
Use a donor-advised fund
A donor-advised fund (DAF) is essentially a charitable investment account through most major brokerages in which you can donate a piece of real estate and get an immediately tax-deductible donation. If you want to plan for the future, you could donate the property now, allow it to appreciate, and bring in income tax-free until it's time to transfer the property. DAFs are gaining popularity, with contributions reaching $29 billion in 2017, according to the National Philanthropic Trust.
Though it can be extremely beneficial, DAFs are highly underutilized for real estate donation -- less than 3% of total charitable giving comes from real estate gifts, according to the American Endowment Foundation.
There are a couple of criteria when going this route, however:
- The property must be heavily appreciated or expected to heavily appreciate.
- The property must generally be free of liens and encumbrances.
Fees for using this vehicle could range from a tenth of a point to over a point, depending on the value of assets in them. If you wish to keep your gift anonymous, this is a good way to do it; just make sure you let your DAF know.
The bottom line
Understanding the tax implications of gifting real estate is no easy task. If, after reading this post, you have further questions about the tax consequences of giving a property as an outright gift or part of your estate, your best bet is to talk to a tax or estate planning professional. They can help you look at the specifics of your financial situation and decide which method of gifting is best for you and give you individualized advice.