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 tax year 2022. For 2023 the exemption is $12,920,000. 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. That’s because of cost basis, which is cost of the property used to determine the capital gain, if any, when it is transferred.
When Real Estate is Inherited
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. The executor may also choose to use the date of death as the basis valuation date. Either way, 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. 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. If the donor purchased the property for $100,000, then your cost basis would be $100,000, even if the property is now worth $350,000. 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 certain thresholds. Below these thresholds, you’d pay no capital gains tax. At very high-income thresholds, the long-term capital gains tax rate increases. Beyond these thresholds long-term capital gains are taxed at the short-term rate (20%).
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 a family member whose income is subject to lower tax rates. For example, that family member could earn up to $41,675 in 2022 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 If You’ve Been Given Real Estate
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.
