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Financing

Giving the Gift of Real Estate? Keep an Eye on Tax Rules

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New home in gift box in front of Christmas tree (© Catherine Lane 2014)

Looking for a Christmas present your children (or parents, partner, or very, very good friend) will never forget?

Skip the Xbox One. Buy a house.

Seem too generous? For most people, it is. In most cities, houses cost hundreds of thousands of dollars -- and even in cities with a low cost of living, dropping a hundred grand on someone else's home is preposterously out of the question.

But say you're in a good position financially, and you're feeling particularly generous this holiday season. Plus, someone you're close to needs the help. Gifting a house isn't a terrible idea, as long as you keep your finances in order. (And as with all financial advice, make sure to run your plans by your tax accountant before diving in.)

Buy a new home outright

For many reasons, most of which should be incredibly obvious, we wouldn't recommend selecting the home you gift and presenting it, sight unseen, to the recipient. You might think you know him or her well, but everyone has myriad opinions and preferences of which you might not have been informed. Maybe the recipient is secretly dying for an in-ground pool despite living in northern Minnesota.

So if you're looking to buy someone a whole house, CPA Drew Aguilar of Carson Valley Accounting in Minden, NV, recommends giving the cash, not the home itself -- it's a far less complicated option, he says.

Here, you're dealing with two types of gift tax limits: The annual exclusion and the lifetime exemption. The annual exclusion allows you to give up to $14,000 tax-free to as many people as you want each year. Any amount over that is subject to the lifetime exemption -- currently $5.43 million, set to increase to $5.45 million in 2016 -- the total that you can give to any number of people during your entire life.

Most people will never reach their lifetime limit, so there are "no tax implications, except they need to file a gift tax return," says Aguilar. And remember, the giver pays the tax, not the recipient.

Gift the down payment

Offering money for a down payment works in pretty much the same way -- except when it comes to the mortgage. If there's even the slightest hint that the money is a loan rather than a gift, it can screw up the recipient's chance of getting a mortgage.

You'll want to work closely with the recipient's lender and mortgage broker to file the appropriate paperwork, which will include a verified gift letter certifying the funds are a gift, not a loan. The lender will likely need to examine your finances to determine if you're able to gift -- if your margins are tight, it might decide the chunk of change you're handing over is actually a loan, despite your protestations.

And this method won't work if you're helping out your buddy: For the most part, lenders won't permit gifts from nonfamily members.

Gift an existing home

Your children would love to own the home they grew up in, and you're delighted to make their dreams come true. But hold up: In many cases, this is a poor option, especially if both parents are still living.

"A gift is a gift, and it's a great thing to happen," says Aguilar. "For the parents, it's a wonderful thing if they want to do it. The house was where the children were raised and it has meaning to them, but all these new factors come into play."

The first, harsh news: You're best off waiting until you or your spouse passes away. One of the tricky struggles with gifting a home you own is the differential between the cost basis (what you first paid for the house) and the current fair market value -- which could be hundreds of thousands of dollars, especially if you bought early in an up-and-coming neighborhood.

This might not matter if your children plan to live in the home forevermore: The gift will be subject to your gift tax limit, and they'll only pay capital gains tax if they sell. But if (and, likely, when) they sell, they'll be stuck paying taxes on the difference. The personal residence exemption allows them to exclude $250,000 ($500,000 if married) from the sale, but in an area with a high cost of living, it might not make much difference. If one of the owners dies, however, your home's value gets a reboot to its current value.

Still determined to gift them your home? You have a few options:

  • A revocable living trust: This option helps your heirs avoid probate fees (basically, all the legal costs that go along with inheriting stuff), and lets you gift your current residence after your passing. While you live, the trust is assigned a trustee -- in most situations, you -- and you can change and revoke the trust at any point.
  • Sell your home for a low, low price: The IRS views selling your home for less than market value as nothing more than a stupid mistake -- unless you do so to a family member. The difference between its value and your cut-rate sale price goes against your lifetime exemption (and you'll want to invoke the annual gift tax rule), but otherwise the sale is tax-free.
  • Provide seller financing to your children: Instead of sending your kids to the bank for a mortgage on their own childhood home, consider seller financing, where you are given a small down payment in exchange for holding the note on the property. Sharing a lawyer and skipping the real estate agent can lower closing costs, making this a win-win arrangement for everyone -- as long as you trust them to pay down the mortgage.

 

As long as you keep an eye on your annual or lifetime exemption, gifting a home is -- for the most part -- a relatively tax-free way to ensure your children, friends, or parents have a safe, affordable place to live.