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I Give You My Heart and My Home- Gift and Tax Income Consequences for Gifting Property

On Behalf of | Feb 15, 2019 | Estate Planning, Tax Law

Meet Wanda and Jane.  They have been a happy couple since January 1, 1986, and celebrated their silver anniversary by registering as Domestic Partners on January 1, 2011.

In 1999, Wanda bought a home for them to share with $600,000 of an inheritance she received from her dear spinster Aunt Jo.  Wanda wants to give ½ of the house, which is now worth $1,000,000, to Jane as a “registration” gift so that they can own it jointly.  The only question Wanda has is whether she will end up owing any taxes if she makes this transfer.

The answer is: It depends.

If Wanda owns the home without encumbrance, the answer is fairly straightforward.  When she transfers title to herself and Jane as their community property, Wanda will be making a gift to Jane of ½ of the current fair market value of the home, or $500,000.

Gift Tax Consequences
Because of the annual gift tax exemption (currently $13,000), Wanda will be deemed to be making a taxable gift of $487,000 to Jane.  This gift tax liability may be offset, however, if Wanda has available to her any portion of her lifetime gift tax exemption amount (currently $5,000,000).  Wanda would simply need to file a federal gift tax return – acknowledging the transfer and electing to use of $487,000 of her lifetime exemption.  This would allow Wanda to make the transfer without incurring any current tax liability, but the amount used in lifetime gifting will be deducted from what Wanda can leave free of estate taxes at her death.

Income Tax Consequences
Where, as in this case, there is a gift of separate property between people who are legally related, and for whom the IRS recognizes community property rights that were given to them by the State of California when they registered, neither party incurs any income tax liability in the initial transfer.  When either party sells the property in the future, however, she may be subject to income taxes on the difference between the sale price and her basis in the property, although, with both of their names on the title, Wanda and Jane will each be eligible for the $250,000 capital gains exclusion at the time of sale.

Determining Basis
Where, as in this case, the transfer is only a gift, the donor (Wanda) will retain her original basis in the ½ of the property she retains, and the donee (Jane) will take her ½ of the property with essentially the same basis.  Wanda’s original basis is equivalent to the purchase price of the house plus any the value of any capital improvements she has made to the property, so her basis in the house after the transfer is equal to ½ of that value.  B’s basis is equal to the same value.  Accordingly, both Wanda and Jane will have a basis of $300,000 in the home (assuming no capital improvements have been made to the home).

The answer changes if, as is often true, the home is encumbered by a mortgage.  In that case, Jane’s assumption by of ½ of the mortgage, which she does whether she signs a note to the lender or not, is in essence a reduction of how much Wanda owes on the loan and is considered to be relief to Wanda from that portion of the debt.  As a result, the transfer will be treated as part gift and part sale because Jane will be treated by the IRS as if she receives a “gift” of that portion of the equity she receives, and as if she “paid” for a portion of the home to the extent that she now owns a share of the mortgage.  This, of course, means that the tax consequences are more complex.

So, let’s assume that all of the facts are the same except that Wanda has an outstanding mortgage of $400,000 on the home.

Gift Tax Consequences
In this case, when Wanda transfers the property to herself and Jane as tenants in common, joint tenancy, community property, or community property with right of survivorship – essentially any form of equal ownership – she will be making a taxable gift to Jane of $287,000, as follows:

Fair Market Value of
½ of property at time of transfer:                         $500,000

(less) Amount of mortgage W “sold” to J:          – $200,000

Gift amount                                                         $300,000

(less) Annual Exclusion                         –  $ 13,000

Total Taxable Gift                                               $287,000

Although this $287,000 would be a taxable gift, as discussed above, Wanda could elect to use $287,000 of her lifetime gift tax exemption to offset the tax liability.

Income Tax Consequences from the “Sale”
In addition to the gift tax issue, where a transaction is part gift/part sale, the transferor (Wanda) realizes a gain for income tax purposes to the extent that the amount she “earns” in the “sale” exceeds her adjusted basis in the property.  Wanda does not, however, realize a loss if the amount she earns is less than her adjusted basis in the property.

Amount Earned
In this case, Wanda will be deemed to have “earned” the amount of the mortgage assumed by Jane in the transfer, which is ½ of $400,000, or $200,000.

Calculating Wanda’s Adjusted Basis:
Wanda’s adjusted basis in the transferred property is essentially equivalent to the original purchase price (including certain closing costs) that she paid for the portion of the property she is transferring to Jane plus ½ of the value of any capital improvements Wanda made to the property.  Since we are assuming Wanda has not made any capital improvements to the property, her adjusted basis in the transferred property would be equivalent to ½ of $600,000, or $300,000.

Because Wanda’s adjusted basis ($300,000) exceeds the amount she earned in the sale ($200,000), she will not be subject to any additional income tax liability as a result of this transfer.

Calculating Jane’s Basis:
Where a transaction is deemed to be part gift and part sale, Jane will take her portion of the property with a basis that is equivalent to (1) the larger of Wanda’s adjusted basis or the amount paid by Jane for the property plus (2) a fractional amount of any gift taxes actually paid by Wanda.

As determined above, Wanda’s adjusted basis is $300,000.

The amount Jane “paid” for the property is equivalent to ½ of the outstanding mortgage, or $200,000.

Although there is a gift tax liability created by this transfer, as discussed earlier, as long as Wanda elects to utilize some of her lifetime gift tax exemption to cover that liability, Wanda will not actually pay any gift taxes.

Accordingly, Jane’s basis in her portion of the property will also be $300,000.  Although Jane’s basis has no bearing on current tax liabilities, is important to know because it will come into play when Jane later sells and/or gifts the property, or when her interest in the property passes upon her death.

The situations discussed here are common to both same-sex and different-sex couples who are not recognized by the IRS in the same manner as different-sex spouses, and the practical results would be the same for either (although the mechanisms for offsetting gift taxes will likely differ).  What is most important to take from this is that just because you (or Wanda) intend to make a gift of property, such a transfer can have real and significant (although unintended) tax consequences.  Accordingly, it is always prudent to check with your lawyer and/or tax professional before making any property transfer.