Giving home comes with many tax complications

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DEAR BENNY: What are the tax complications, if any, on giving my home to my brother as a gift? –Ed

DEAR ED: There are several potential complications, for both you and possibly your brother.

Let’s take you first.

If the house is valued at more than $13,000, you will have to file a gift tax return. No tax will have to be paid at that time, but it could impact your estate.

Currently, the lifetime unified gift/estate tax is $5 million, with portability feature for spouses. And the annual gift tax exclusion is $13,000. So the value of your house over $13,000 will reduce your overall $5 million gift/estate tax exemption.

Some people with significant assets would do the transfer during lifetime so that any appreciation of the property is out of the estate. But, this can impact on your brother.

Let’s assume for this discussion that you bought your home 10 years ago for $200,000 and now — even with current market conditions — it is worth $300,000. When you gift the house to your brother, your tax basis, which is $200,000, becomes the tax basis for your brother. Of course, if you made any substantial improvements, that would increase the tax basis.

So now your brother’s tax basis is $200,000. Tax basis is important in determining profit. You take the purchase price and add any improvements to get an adjusted tax basis. Then you take the sales price and deduct any expenses, such as real estate commissions, to get the adjusted sales price. The difference between the adjusted sales price and the adjusted tax basis is profit.

Let’s say your brother decides to sell immediately for $300,000 and, for this discussion, ignoring expenses, his gain is $100,000 ($300,000 minus $200,000). In that case, unless he has held the property for at least 12 months, he will have to pay income tax based on his ordinary tax rate.

If he sells after one year, one of two scenarios can occur. If he has lived in and owned the property for two out of the five years before the property is sold, he can take advantage of the up-to-$500,000 exclusion of gain. If he is married, and files a joint tax return with his spouse, they can exclude up to $500,000 of their profit; on the other hand, if he is single, or files a separate tax return, he can exclude only up to $250,000 of his gain.

On the other hand, if he cannot meet the “use and occupancy” tests referenced above, then he will have to pay capital gains tax on his profit. In 2010, the maximum tax was 15 percent. Congress has extended this through 2012.

If you are in the 10 or 15 percent income tax bracket, you do not have to pay any capital gains tax if you sell your investment property or cannot meet the use and occupancy tests. All other taxpayers will still have to pay only 15 percent of the gain. Because next year is an election year –and Congress is so hopelessly divided (as of this writing) — no one can predict the future of the tax laws.

There is one additional factor to consider before gifting property. As discussed above, if you gift someone your home, your tax basis becomes their tax basis. On the other hand, if you die and leave the house to someone, that person gets what is known as the “stepped-up” basis. In other words, the value of the property at the time of death becomes the tax basis for the new owner.

In our example, if you die and leave your brother the house, which was valued at $300,000, and if he sold it immediately for $300,000, he would have no gain and thus no tax to pay.

This is not complicated, but does require careful planning. Consult with your tax advisers before taking any action.

Benny Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to [email protected].