A gift of real property before death may significantly affect income tax consequences

Law Offices of Fred M. Duman & Associates
2807 Castro Valley Boulevard     Castro Valley, California 94546
Tel: (510) 537-3388 Fax: (510) 889-1114

Dear Mr. Duman:

My father is getting on in years.  He has a rental, which he bought in 1962.  He is thinking about deeding the rental to me and my wife as a gift, as opposed to leaving it to us in his Will.

I've heard that there may be different income tax consequences for us, depending on whether real property is transferred during my father's lifetime or upon my father's death.

What can you tell me about this?

       F.H., Livermore


Dear F.H.:

As you suggest, whether you take ownership of your father's home before or after his death will significantly affect the income tax consequences for you when you eventually sell the property.  If your father deeds you the property during his life as a gift, your "basis" in the property will be the same as your father's.  If your father were to die with the property in his estate, your basis would be a "stepped up" basis.

To explain, the "gain" which is realized from the sale or exchange of property is considered "gross income" as to the owner, who is disposing of the property.  For purposes of determining income tax liability, "gain" is defined as total "amount realized" from the sale or exchange of real property, minus the amount of the property's "adjusted basis".

Internal Revenue Code Section 1001(b) specifies that the "amount realized" by the sale/exchange of real property includes all money received from the transaction, less the qualified expenses of fixing up the property in preparation for the sale, plus the fair market value of all other property or services received in exchange for the subject property.

In order to deduct expenses incurred in fixing up the property from the "amount realized", the expenses must have been incurred within 90 days prior to the date the sales/exchange contract was signed and must be paid no later than 30 days after the date the property was sold.  There also are various other Internal Revenue Code limitations which may restrict the deductibility of such expenses.

The "adjusted basis" consists of the property's original cost, plus the cost of capital improvements to the property and less any depreciation/depletion.  The "adjusted basis" must be subtracted from the "amount realized" to arrive at the amount of "gain" attributable to the transaction. The "gain" is considered part of the owner's gross income for tax purposes.

Since your father purchased the subject property in 1962 and has used it as a rental, it is likely it has been "depreciated" substantially.  We would anticipate that your father's "adjusted basis" is quite low.

When the property is transferred as a gift, while the previous owner is still alive, the previous owner's original basis is transferred to the new owner, who must apply the original basis when calculating the capital gains tax realized upon the new owner's eventual sale of the property.  However, when the property is received by testamentary transfer, a new "stepped up" basis will be applied to the property.  The "stepped up" basis will be equal to the fair market value of the property at the time of the transferor's date of death.

In other words, if the property is inherited by you, when you later sell this property, your "gain" will be substantially smaller, based on the difference between the "stepped up" basis and the "amount realized" upon sale.  However, if you receive your father's property, while he is still alive, your capital gain upon the later sale will be much greater because your father's "adjusted basis" will be much less than the "stepped up" basis which would be applied to the property upon your father's death.

With some exceptions, if property has been sold after May 6, 1997, and the "gain" is "long term", and it is incurred by an individual, the maximum tax rate for the "gain" would be twenty percent (20%).

Further questions regarding the transfer of your father's home and the tax consequences, thereof, as well as questions regarding the disposition of his estate, generally, should properly be addressed to your lawyer.

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This page last updated September 9, 1999.
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