Unintended Consequences
There are unintended consequences potentially hiding in the most altruistic or generous of decisions. Take a friend of mine for example. My friend is a homeowner. One of their parents owns multiple homes. For some reason, the parent thought it would be a good idea to sell one of the homes to my friend at just over what the parent originally paid for the home.
Considering that the purchase price of the home was around $300,000 and the home’s current value is $1.5 million, that is a lot of generosity in that decision. There is also an unintended consequence. That consequence is known as a “Gift of Equity.”
What does that mean in English? The difference between the home’s market value and the below market sale price in my friend’s situation is $1.2 million dollars. Now the parent probably would not have to pay gift tax, although they would have to file a Gift Tax Return, IRS Form 706. It isn’t the most difficult form to complete, although it can be a bit challenging. When would the parent be subject to the gift tax? Only if the cumulative total of gifts that had to be reported in their lifetime exceeded the Basic Exclusion Amount (BEA). In 2022 the BEA is set at $12,060,000. My friend’s parent would pay no gift tax.
Raising the question, where is the real consequence? It comes when my friend goes to sell this home. Assuming the market value of the home had increased to $2,000,000 (the house is in Southern California after all), that would mean a capital gain of $1,700,000 on the transaction. The tax on that gain would be $404,600 on their federal and around 12% for California. One of the reasons that California has those big budget surpluses that Governor Gavin Newsom keeps talking about is that the state of CA treats long-term capital gains like ordinary income.
In fact, if my friend sold the home before a year and a day from the purchase date, that federal tax bill would increase to over 40%. That’s because short-term capital gains are treated as ordinary income on the federal return.
Was this big tax bill avoidable? Yes! If the parent doesn’t make a gift of equity and instead lets my friend inherit the home, there would be no gift of equity. My friend’s cost basis in the home would be the fair market on the date the parent passed away. They could sell the house immediately and pay NO tax on the sale. When hearing this, my friend chose to not buy the house at below market value.
The moral of the story. Before making a major decision, consult with the appropriate expert.
Considering that the purchase price of the home was around $300,000 and the home’s current value is $1.5 million, that is a lot of generosity in that decision. There is also an unintended consequence. That consequence is known as a “Gift of Equity.”
What does that mean in English? The difference between the home’s market value and the below market sale price in my friend’s situation is $1.2 million dollars. Now the parent probably would not have to pay gift tax, although they would have to file a Gift Tax Return, IRS Form 706. It isn’t the most difficult form to complete, although it can be a bit challenging. When would the parent be subject to the gift tax? Only if the cumulative total of gifts that had to be reported in their lifetime exceeded the Basic Exclusion Amount (BEA). In 2022 the BEA is set at $12,060,000. My friend’s parent would pay no gift tax.
Raising the question, where is the real consequence? It comes when my friend goes to sell this home. Assuming the market value of the home had increased to $2,000,000 (the house is in Southern California after all), that would mean a capital gain of $1,700,000 on the transaction. The tax on that gain would be $404,600 on their federal and around 12% for California. One of the reasons that California has those big budget surpluses that Governor Gavin Newsom keeps talking about is that the state of CA treats long-term capital gains like ordinary income.
In fact, if my friend sold the home before a year and a day from the purchase date, that federal tax bill would increase to over 40%. That’s because short-term capital gains are treated as ordinary income on the federal return.
Was this big tax bill avoidable? Yes! If the parent doesn’t make a gift of equity and instead lets my friend inherit the home, there would be no gift of equity. My friend’s cost basis in the home would be the fair market on the date the parent passed away. They could sell the house immediately and pay NO tax on the sale. When hearing this, my friend chose to not buy the house at below market value.
The moral of the story. Before making a major decision, consult with the appropriate expert.
posted by me at 11:25 AM
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