Gift Tax vs. Estate Tax

You may believe that "selling" your house to your kid would assist you in avoiding inheritance taxes in the future at the time of your death, but the Internal Revenue Service is one step ahead of you in this situation. Both the federal gift tax and the federal estate tax are intertwined with one another. Timing is the primary factor that differentiates them from one another. When do you plan to make the change in ownership of the assets?

You can pay a tax on the transfer immediately in the form of a gift tax, or your estate may pay the tax later. Both of these levies qualify for the same tax exemption from the federal government. The size of your assets and the number of charitable contributions you make throughout your life will both play a role in determining whether or not you will be required to make a tax payment.

If After the Sale You Don't Use the Property Anymore

Consider the scenario where you sell your house to your kid for the sum of one dollar, even though it originally sold for $200,000, and you no longer live there. Because the IRS considers the remaining $199,999 a gift, it must be subject to federal taxes even though it did not receive any compensation for its worth.

As of 2022, the tax legislation will allow for a gift tax yearly exclusion of $16,000 per person per year; hence, a gift of $199,999 will be reduced to $183,999. You are exempt from paying tax on the first $16,000 you earn, but you will now have to decide which option is best for you.

You can either pay the gift tax on that amount in the year you make the gift or use that amount toward your lifetime exemption. The choice is yours. This exemption will cost $12.06 million beginning in 2022, an increase from the previous $11.7 million in 2021. You will not be subject to a gift or an estate tax if you give away up to that amount in any form, whether during your lifetime or from the proceeds of your estate after your passing.

What Are Your Options If the Recipient Decides to Sell the Property?

When you give a gift to your kid during your lifetime, they will inherit your tax basis, which is how much you spent on the property. This happens when you transfer the property to them as a gift. If they turn around and sell the home for its current worth of $200,000, but you only paid $50,000 for the property in the past, then they are required to declare and pay tax on a capital gain of $150,000, which is the sales price reduced by the amount you paid for the property.

However, there is a "step up" basis if you keep the property and transfer it to a beneficiary as part of your inheritance. This occurs if you keep the property after you pass away. In this scenario, your child's basis will be converted into the property's date-of-death value. If your kid sells the home for $200,000, which is its fair market value, there will be no capital gain, and your child will not be required to pay any capital gains tax.

Should You Proceed to Make Use of the Property

After selling the home for one dollar, the situation will be different if you continue to live in it and use it as a residence. Because you continue to use the home as your primary residence, the property's full value will be included in your gross estate and will be liable to estate tax. The Internal Revenue Service contends that the contract required you to continue living in the home even after you sold it.

To put it another way, you and your kid agreed to this: "I will sell you my home for one dollar, but you will let me live there for as long as I want." Because of this, the tax authorities have effectively established that such an agreement exists, even if it is not documented in writing. The $12.06 million lifetime exclusion waiting in the wings to take care of things is not necessarily a negative consequence.

You Rent the Home Instead

There are some people who believe that paying their rent is the solution; nevertheless, this won't be of any assistance either. If you retain the income from the property or the use and occupancy of the property after it has been transferred during your lifetime, then the full value of the property is considered part of your estate. This general rule applies whenever any property is sold during your lifetime.