The tax consequences of giving away the house

If you own a second home, vacation property or even a primary residence that has gone up in value, you may be considering taking action to capture and then benefit from the appreciation. But what is the most tax-efficient choice from a wealth transfer planning perspective?

Should you sell now and use the proceeds to make gifts to your heirs? Should you gift the property? Should you keep the property and pass it on to your beneficiaries as part of your estate? These questions may not be easy to answer, depending upon your circumstances. Here are primary points to consider as you evaluate your options.

Think about the income tax implications

When property has gone up in value, the temptation is great to benefit from that appreciation by selling the property, especially with second homes or vacation properties that you may not use as often any more as family members grow up, move away and their 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 your state of residence and the location of the property, your total tax impact could be much higher. For example, in California your proceeds could be reduced by as much as 36.1% after paying combined federal and state income taxes.

 Planning strategies to mitigate income taxes

The first thing to consider is whether to sell the property. If you continue to hold your property during your lifetime and pass it to your children or other heirs as part of your estate, under current law your heirs will receive a “step-up” in income tax basis. From a tax perspective, your heirs are able to sell the property immediately following your 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 your death. The only income tax due will be attributed to the small amount of appreciation that occurs between date of death and date of sale.

You can also consider putting off a sale and look at how you use a property. If you convert a property into your primary residence, you can exclude $250,000 of gain from income taxes (or $500,000 for a married couple) if you have used the property as your primary residence for two out of the previous five years. Alternatively, if you convert the property into a rental property, you 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 you do decide to sell the property, you can look at your other investments, including marketable securities, to harvest capital losses to offset the gain on the sale of the property.

Would it make sense to gift a property to beneficiaries?

From a tax perspective, a gift will likely only make sense if your assets will be subject to estate taxes. If your assets are under the estate tax exemption ($13.61 million per individual or $27.22 million for a married couple in 2024), a gift could actually be a bad decision for tax purposes because you achieve no savings from estate or gift taxes and,  by gifting the property during your lifetime, you would be sacrificing the benefit of receiving the “step-up” in capital gains cost basis at your death.

If your gross taxable estate is going to be over these transfer tax exemption amounts, however, you may see 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” in basis, especially if you believe the property value will continue to appreciate. It's also important to remember that our current high estate tax exemptions are scheduled to sunset and revert to roughly half the current amounts in 2026 (with inflation adjustments).

Gain tax advantages by giving partial value over time

One strategy that can be used to help mitigate gift and estate tax is to gift partial interests in a property. For example, you could give a 25% interest in a property to each of your four children. Alternatively, you could give a 25% interest in a property to a child one year and give other percentage interests in future years. Complications exist when 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. The lack of marketability and minority interest discounts allow you to pass more value onto your beneficiaries while using less of your tax-free transfer exemption amount (or pay less gift tax if you’ve exceeded the exemption with past gifts).

Gift your property and continue living there

Finally, an option often used with vacation homes and sometimes even with a primary residence is a Qualified Personal Residence Trust or “QPRT.” A QPRT enables you 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 your estate. The value of the gift is also reduced by the actuarial value of your retained right to live in the property for a term of years, and by your retained right of reversion (that is, the right to have the property return to your estate if you die before the end of the term of years).

The longer the period or the older you are, the greater the reduction in the value of the gift, which can often be a planning opportunity for older clients who are in great health. If you die during the period of the QPRT, the gift fails and the residence is included in your estate for estate taxes (along with the corresponding step-up in basis). But if you survive the period, the residence is passed onto your beneficiaries with significant tax savings.

Your Fiduciary Trust estate and tax planning advisers can help you determine if a QPRT or any of these other planning strategies are right for you.