Let's assume you’re rolling in the dough like Bobby Axelrod and you're feeling so generous that you might just simply give your home to your adult child. Lucky kid!
Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.
If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.
If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.
If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.
Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.
Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.
Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you depart this planet. In these scenarios, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child
Side bar. Melissa and I bought a rental house in 2018 that we plan to use for our daughters college fund. We put it on a 15 year mortgage and the tenants effectively pay it with their rent. By the time our daughter is ready for college, we estimate the property will be worth $350,000 and we'll give her the option of either 1) accepting the cash flow it generates ($3,000 per month) to fund a business of her own or 2) selling it to pay for school so she can be debt free. If she chooses the former, we will be selling it to her using this method and maybe with a twist with what you'll see in Option 3
The idea of giving your home-starved child a big free lunch might be unappealing. Very well.
Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price.
Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).
AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In April 2022, the long-term AFR, for loans of more than nine years, is only 2.25 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 1.87 percent (assuming annual compounding).
As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.1 percent, while the rate for a15-year loan was around 5.6 percent.
So, for a loan made in April 2022, you could take back a 30-year note that charges the long-term AFR of only 2.25 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 1.87 percent. Either arrangement would be a money-saving deal for your child.