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Capital Gains vs. Inheritance Tax and Probate

I am often asked about the pros and cons of an elderly parent’s transfer of the family home to the children. This subject arises when a parent is widowed, enters “the golden years,” or when there is a growing concern about admission to a nursing home.

There are several positive financial aspects concerning such transfers. Real estate owned at the time of a person’s death is subject to Pennsylvania Inheritance Tax, assessed on the fair market value on the date of death. (The exception is property is jointly owned with a spouse, in which case there is no tax when the first spouse dies.)

Pennsylvania inheritance taxes are also assessed against transfers made without “adequate consideration” (e.g., gifts) within 1 year of a person’s death. If a parent transfers the family home to an adult child or children without retaining any ownership interest, there will be no inheritance taxes providing the transfer is made and recorded more than 1 year before the parent’s death. If the parent transfers the entire asset, or retains an interest as a joint tenant with rights of survivorship, and death occurs within 1 year, the date of death value of the house is taxable. If the death occurs more than 1 year after the transfer, then only the parent’s retained interest is taxable. However, in both cases, probate regarding the house is avoided because the property will be owned by the child upon the parent’s death. If the parent retains an interest as a “tenant in common,” then upon the parent’s death, that interest constitutes part of the estate, which is taxable and must be handled through probate.

For example, if a parent deeds an $80,000 home to their child at least 1 year before their death, the following taxes would be saved: Pennsylvania inheritance taxes of 4-1/ 2%, or $3,600; and at least $1,600 in Pennsylvania (1%) and local deed transfer taxes. If attorney’s fees for probating the estate to transfer the house to the children were estimated at 4% to 5%, there would be a further savings of $3,200 to $4,000. If the parent merely added a child to the deed as a joint tenant with rights of survivorship, inheritance taxes would be reduced by half, and there would be no probate charges or fees.

This scenario may, however, be “too good to be true.” This is because when real estate is transferred without the child paying fair market value (money) for the property, this method of transferring property may merely trade one type of tax for another, higher tax – capital gains tax.

Inheritance taxes and income taxes are two separate and different taxes. With a few exceptions for IRAs, annuities and bond interest, assets received as an inheritance are not considered income, and inheritances are not subject to income taxes. However, if a parent transfers real estate to a child, and the child sells the property later, there is most likely going to be capital gains on the sale, which is taxed to the child, as the seller.

When property is received as a gift, the “donee,” (child) assumes basis of the “donor” (parent) in the property. “Basis” is the donor-parent’s cost of the property adjusted for improvements and allowable costs of sale. Capital gain – the difference between the basis and the property’s gross sales price – is subject to PA and Federal income taxes. Thus, after having received the parent’s home as a gift, if the child sells the property, the difference between the selling price and the basis assumed from the parent is taxable to the child as a capital gain. The current maximum federal tax rate is 15%, and the state tax is a flat 3.07%. The “one time exclusion” is not available to a child who is under 55 years of age when the sale is made or if the child hasn’t resided in the home as his or her primary residence during 3 of the 5 years prior to the sale.

Under the example of the $80,000 home, inheritance taxes, transfer taxes and attorney and probate fees totaling between $8,400 to $9,200 could have been saved. However, if the parent had paid $15,000 for the home and made $10,000 in improvements, for a basis of $25,000, a sale for $80,000 would yield a $55,000 capital gain upon a sale by the child. This can result in federal income taxes of $8,250 and PA income taxes of $1,688.50 for a total tax bill of $9,938.50!

If, however, the parents own that home until their death, and pass it to their child through probate, then the child acquires the property at a “stepped-up” basis – i.e., the “basis” attributed to the property in the child’s hands is the date of death value – in this case, $80,000. Therefore, upon the parents’ death, property of $80,000 is inherited with perhaps $7,600 maximum due for inheritance taxes and probate fees (there are still no transfer taxes). BUT, if the property is sold for $80,000, there is no capital gain, which results in a savings. Even if the property is held for a few years and increased in value, the capital gain is minimized because it is measured against the “stepped-up” basis.

Every family has different circumstances and different priorities concerning the family home, which is often a parent’s major asset. The important thing, however, when deciding whether real estate should be retained by a parent or transferred to the children is to be aware that capital gains taxes can lurk in the background. By being aware of the taxes and fees involved with a transfer or retention of real estate, you should be able to either minimize the tax consequences to your family or at least prepare with open eyes for the “capital gains tax surprise.”

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