There is a famous saying, usually attributed to Benjamin Franklin, who wrote in a 1789 letter that “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” In all fairness, Benjamin Franklin did not know the difference between basis in property received as a gift vs basis in property received through inheritance as of April 23, 2017; but for this blog post we are going to assume otherwise. Acquiring property either as a gift or through inheritance can, and often times will, have major implications on tax liability at the date of disposition.
Property Acquired by Gift
As a general rule, the basis of property acquired as a gift is the basis the donor had in the property prior to the gift, adjusted for any gift tax paid on the transfer (for this blog post we are ignoring gift tax implications). To make this clear, lets look at an example.
John’s grandma is getting up there in years and is tired of maintaining her home in upstate New York. She would much rather be in a condo in Florida living out her golden years on South Beach; margaritas, bikinis and wild nights playing bingo. She doesn’t want to sell her home because her grandfather built the home and passed it down through the generations. She doesn’t want to leave the home to her estate after her death because she would much rather see one of her relatives enjoy the home while she is still living; so she decides to gift the home to John.
For this example lets assume her basis in the property is $100,000 and the fair market value of the home the date the property was gifted is $350,000. This means that if John were to sell the home the day after he received it, assuming he was able to sell the home for $350,000, he would pay taxes on a $250,000 gain ($350,000 proceeds from the sale less $100,000 basis). Why is this? Remember the general rule, John’s basis in the property is the same as his grandma’s basis prior to the gift. Selling the home would not only break his poor grandmother’s heart but it would also incur a massive tax liability.
You get a house, you get a house, everybody gets a house!!!
Now let’s make this interesting. John decides that he would rather not break his grandmother’s heart nor pay a sizable portion of the proceeds from the sale of the home to the IRS. John can use the home as his main residence for two out of the next five years and use the $250,000 exclusion to avoid paying any tax at all. If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income ($500,000 if you file married filing jointly). In general, to qualify for the exclusion, you must meet both the ownership test and the use test. You’re eligible for the Section 121 exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.
However, John lives and works in White Plains and the commute from his grandmother’s house to his job is an hour and a half in both directions. So John decides to rent the home instead. He rents the home for $1,200 a month totaling $14,400 annually. He is able to depreciate his basis of $100,000 over 27.5 years and is able to deduct real estate taxes, repairs and maintenance, landscaping and management fees paid to collect rent and upkeep the property. For tax purposes the property is break even but John is able to net about $3,700 in cash annually.
Some time goes by and John’s grandma passes away. John decides now is the perfect time to get rid of the home. However, selling the house would net even higher capital gain because of recapture rules for rental property that has been depreciated. So John devises a plan to gift the property to his older uncle Bill and to ask Bill to list him in his estate.
Property Acquired by Inheritance
Now this is where it get’s really interesting. John, being the savvy accountant that he is, knows that the basis in property acquired by inheritance is generally the fair market value on the date of death, or 6 months after the date of death if an election is made. By gifting the property to Bill the basis in the property remains at the $100,000 less any depreciation already taken plus any substantial improvements made to the property. So for the sake of this example lets assume the improvements equaled the total depreciation already taken and the basis in the property is still $100,000. Some years go by and Bill passes away leaving all his assets to his loved one. Unbeknownst to John, Bill changed the beneficiaries of his estate and named John’s nephew, Joe, as the beneficiary of the home (drama bomb!!). Since Joe inherited the property, his basis at the time of death is equal to the fair market value. At this time the home is now worth $400,000 and Joe sells the home shortly after for this same amount. Joe, a 22 year old art major, buys an RV with the proceeds and invest in municipal bonds. He lives off the tax free interest and travels the continental US making and selling poetry at local art fairs. Because his basis in the home equaled the fair market value at the date of Bill’s death, Joe was able to receive $400,000 tax free.
Of course this is an exaggerated example and there are many exceptions to the general rules. But the main point you should get from this blog post is the difference between property acquired by gift vs property acquired by inheritance. John’s grandmother could have set up a trust, gifted the property to another relative or simply held on to the property until the date of her death. The point being, each action you take can have major implications on the taxation of real estate property. Planning with a CPA or financial adviser will save time, money and headaches down the road.