Parents often desire to pass their primary residence or vacation property to their children for various reasons. They will often ask: “Should I make this gift while we are still living?” “Is it better to transfer the property now, or let my children inherit it?” The property will usually have appreciated in value over the years, and the parents may not want to sell the property and recognize gain, or they might want to keep the property in the family. Often, answering these questions from a tax perspective depends on the value of the parent’s estate compared to the parents’ estate tax exemption.
Estate Under Estate Tax Exemption
If the estate is not large enough to incur estate tax and barring other non-tax considerations, it is likely more tax-efficient to retain the property in the estate.
Gifting the property is not a taxable event, but with the gift, the parents transfer their basis in the property—the original purchase price, plus the cost of improvements—to the children. This means when the children eventually sell the property, they will recognize gain for any amount in excess of their parents’ basis. If the parents purchased the property many years ago, the sale will likely trigger a high tax liability.
Instead, if the parents let the children inherit the property at the death of the surviving parent, the property will receive a “step-up” in basis to the fair market value of the property upon the date of death of the surviving parent,. When the children later sell the property, they will only recognize gain for any amount in excess of the fair market value of the property at the survivor’s date of death.
To give an example: Ricky and Lucy Ricardo bought a lake house 25 years ago for $250,000 and want to pass on the property to Ricky Jr. and his family. Today, the property is worth $650,000 and continues to appreciate. We’ll assume Ricky dies in 2020, then Lucy dies in 2024 when the property is worth $950,000, and Ricky Jr. sells the property in 2026 for $1.2M.
If the Ricardos gift the property to their son today, Ricky Jr. receives their basis of $250,000, and when he sells the property in 2026 for $1.2M, he realizes gain of $950,000. At a potential tax rate of 23.8%, Jr. pays $226,100 in federal income tax, plus state tax.
If the Ricardos instead hold the property until Lucy dies in 2024, Ricky Jr. inherits the property and his basis is stepped up to $950,000. When he sells the property in 2026, he only recognizes $250,000 gain and taxed at 23.8%, only pays $59,500 federal tax (plus state tax) on $1.2M sale proceeds.
Estate Over Estate Tax Exemption
If the estate will incur an estate tax, it could be more efficient to gift the property to the children, usually through one of several types of trusts. Though circumstances vary, this strategy is based on the concept that it is often more efficient to pay 23.8% tax on the gain at a future sale date, rather than 40% estate tax on the entire value of the property at death. Gifting the property also removes all future appreciation of the property from the estate, and if done with a trust such as a Qualified Personal Residence Trust, it is possible for the parents to enjoy ownership and control a while longer, while reducing the value of their estate and the tax exemption used on the gift.
Remember that just because a property may be under the estate tax exemption now, it may not always be. The estate tax provisions of the Tax Cuts and Jobs Act expire at the end of 2025, so individuals outliving this tax change will want to readjust their estate plans accordingly when the exemption changes from $11M to $5. As seen in the previous example, Lucy’s entire estate plan may be frustrated if she does not plan for a post-tax reform death.
Complicated individual situations combined with a changing and expiring tax code require granular, custom-designed estate planning. If you have questions about this or other estate planning options, contact John Ure or one of our experienced estate tax advisors today at 301.231.6200.