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15 07 2007

Estate - Do You Owe Taxes On That Gift?

Posted by: Eric Hundin in , Estates, Wills, Trusts, Career Information, Blog Carnival

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Many readers of this column take me up on my offer for free financial advice. Mr. K from Michigan, like many, wondered about taxes owed on his mothers house. Chances are you will deal with the same issues.

He writes, I have a question about my mom’s home that I inherited. Before my mom died she put her real estate into joint ownership between her and my sister. It was supposed to help make settling her estate easier. Before mom passed away, my sister died. After my sister died, mom placed the real estate jointly between herself and me. Mom passed away over a year ago and I am now contemplating the sale of her house. After mom’s death I had the home transferred to my and my wifes names.

What are my capital gains liabilities on the sale of the house? Do I pay capital gains on the whole sale, half the sale, or none of the sale?

Mr. Ks question provides an excellent opportunity to clarify the confusing matter of gifting and inheritance. Few people are aware of the tax implications and needlessly end up creating a tax headache for themselves and their loved ones.

Lets explain what an inheritance is and how it differs from a gift. An inheritance is money, property, or another asset of value that is transferred after death. A gift occurs when money, property or other assets are transferred before death. An inheritance and a gift are handled very differently from a tax standpoint.

Each of us can give gifts up to $12,000 per year to any person we want without any Federal tax implications. (There may be some state gift tax implications so check with an accountant.)

Inheritances arent subject to Federal Estate Tax unless the estates value is over a certain amount, which as of January 1st, 2006 is two million dollars. Because all assets owned by the deceased are included in the estates valuation (i.e. retirement accounts, annuities, life insurance, etc.), reaching that two million dollar limit is easier than you think.

Even if there is no gift or estate tax when the assets are transferred, there can be capital gain taxes when the assets are sold. The trick is determining the assets original value, or cost basis, and that depends on whether the asset was a gift or an inheritance.

When you receive a gift, you also receive the cost basis the person giving the gift had. So, if a parent paid $10,000 for a home and it was worth $100,000 when it was gifted to the child, the child now has a
cost basis of $10,000. If the house is sold 5 years later for $125,000, the child will owe taxes on a gain of $115,000.

If the house was instead inherited by the child, the cost basis is the value of the house at the time of inheritance, which in our example would be $100,000.

So when the house is sold 5 years later for $125,000, the child only owes taxes on the gain of $25,000. In tax parlance, the house received a step-up in basis when transferred after death. It doesnt if transferred prior to death.

Lets apply this to Mr. Ks situation. When Mom added Sisters name to the deed, it was a gift to the sister of 50% of the value of the home and sisters cost basis was 50% of Moms cost basis.

When sister died and the house transferred back to Mom, it was considered an inheritance. So Moms cost basis on the 50% she inherited was the market value at the time she inherited it back. So 50% of Moms ownership is based on her original cost basis and the cost basis of the other 50% is the value at Sisters death.

When Mom then adds Mr. Ks name to the property, its another gift. So Mr.K will inherit 50% of Moms new, adjusted cost basis. When Mom dies and the other 50% is transferred to Mr. K, his cost basis in that 50% is the value at the time of Moms death.

Now you know why accountants make all that money!

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moving house can be a pain when you are trying to handle your hyperactive kids while instructing the moving men with the expensive sofa.

This entry was posted on Sunday, July 15th, 2007 at 9:37 am and is filed under , Estates, Wills, Trusts, Career Information, Blog Carnival. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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