If your client owns a second home, vacation property or even a primary residence that has gone up in value, he may be considering taking action to capture the appreciation. But what’s the most tax-efficient choice from an estate planning perspective? Should he sell now and use the proceeds to make gifts to his heirs? Should he gift the property? Should he keep the property and pass it to his beneficiaries as part of his estate?
Tax Considerations for Appreciated Property
When property has gone up in value, it’s tempting to capture the appreciation by selling the property, especially with second homes or vacation properties that aren’t used as often as children grow up and lives get busy.
But any sale of appreciated property has potential income tax costs. Capital gains taxes alone can be as high as 23.8%, and, depending on the state of residence and the location of the property, total tax impact could be much higher. For example, in California, proceeds could be reduced by as much as 36.1% after paying combined federal and state income taxes.
Planning Strategies That Can Help Mitigate the Income Tax Costs
The first thing a client should consider is whether or not to sell the property. If he continues to hold his property during his lifetime and then pass it to his children or other heirs as part of his estate, his heirs will receive a “step-up” in income tax basis. From a tax perspective, this means they can sell the property immediately following his death with no income tax cost. Their income tax basis in the property will be equal to the fair market value of the property at the time of the client’s death. There will only be income tax due on any appreciation that occurs after that time.
Your client can also consider putting off a sale and looking at how he uses a property. If he converts a property into his primary residence, he can exclude $250,000 of gain from income taxes (or $500,000 for a married couple) if he used the property as his primary residence for two out of the previous five years. Alternatively, if he converts the property into a rental property, he may be able to exchange the property into another investment property of equal or greater value down the road, without recognizing capital gain.
Last, if he does decide to sell the property, he can look at his other investments, including marketable securities, to harvest capital losses to offset the gain on the sale of the property.
When It Makes Sense to Gift a Property
From a tax perspective, a gift will likely make sense only if your client’s assets will be subject to estate taxes. If his assets are under the estate tax exemption of $11.4 million or $22.8 million for a married couple (both as of 2019), a gift could actually be a bad decision for tax purposes. This is because there are no estate tax savings. And, by gifting the property during his lifetime, he would be sacrificing the benefit of receiving the “step-up” in capital gains cost basis.
If your client’s assets are over these transfer tax exemption amounts, however, there can be significant estate tax savings by making a gift. And with an estate tax rate of 40%, those savings may more than offset the income tax implications of not receiving the “step-up” basis, especially if he believes the property value will continue to appreciate. It’s also important to remember that our current high estate tax exemptions are scheduled to sunset in 2026 and revert to roughly half the current amounts, subject to inflation adjustments.
Decreasing the Value of a Gift
One strategy that can be used to help mitigate gift and estate tax is to gift partial interests in a property. For example, a client could give a 25% interest in a property to each of his four children. Alternatively, he could give a 25% interest in a property to a child one year and give other percentage interests in future years. There can be complications in co-owning property with family members, but the value of a partial interest is typically subject to a discount of at least 20% off the pro rata share of the property’s value as a whole. This allows a client to pass more value onto his beneficiaries while using less of his tax free transfer exemption amount (or pay less gift tax if he’s exceeded the exemption with past gifts).
Gifting Property and Continuing to Use It
An option often used with vacation homes and sometimes even with a primary residence is a qualified personal residence trust (QPRT). A QPRT enables a client to gift a residence into an irrevocable trust and retain the right to live in the residence for a period of years.
For estate tax purposes, the gift moves the residence and any future appreciation of its value out of his estate. The value of the gift is also reduced by the actuarial value of his retained right to live in the property. The longer the period or the older he is, the greater the discount, which can often be a planning opportunity for older clients who are in great health. If he dies during the period of the QPRT, the gift fails and the residence is included in his estate for estate taxes. But if he survives the period, the residence is passed onto his beneficiaries with significant tax savings.