- Family Member Transactions
- Renting to a Relative
- Below-Market Loans
- Transferring Home Titles
- Life Estate
When it comes to transactions between family members, the tax laws are frequently overlooked, if not outright trampled upon. The following are three commonly encountered situations and the tax ramifications associated with each.
Renting to a Relative – Whenataxpayerrentsahometoarelativeforlong-termuseasaprincipalresidence,the rental’s taxtreatmentdependsuponwhetherthepropertyisrentedatfairrentalvalue (the rental value of comparable properties in the area) oratlessthanthefairrentalvalue.
RentedatFairRentalValue– If thehomeisrentedtotherelativeatafairrentalvalue,itistreatedasanordinaryrentalreportedonScheduleE,andlossesareallowed,subjecttothenormalpassivelosslimitations.
RentedatLessThanFairRentalValue–Whenahomeisrentedatlessthanthefairrental value,itistreatedasbeingusedpersonally by the owner; the expenses associated with the home are not deductible, and no depreciation is allowed. The result is that all of the rental income is fully taxable and reported as “other income” on the 1040. If the taxpayer were able to itemize their deductions, the property taxes on the home would be deductible, subject to the $10,000 cap on state and local taxes effective starting with 2018. The taxpayer might also be able to deduct the interest on the rental home by treating the home as their second home, up to the debt limits on a first and second home.
Possible Gift Tax Issue – Therealsocouldbeagifttaxissue,dependingif the differencebetweenthefairrental valueand the rentactuallychargedtothetenant-relative exceeds the annual gift tax exemption, which is $15,000 for 2018. If the home has more than one occupant, the amount of the differencewouldbe prorated to eachoccupant,sounlesstherewasalargedifference($15,000 peroccupant,in2018)betweenthefairrentalvalueandactualrent,orothergiftingwas also involved,agifttaxreturnprobablywouldn’t be neededinmostcases.
Below-Market Loans – It is not uncommon to encountersituationswherethereareloansbetweenfamilymembers,withnointerest beingchargedorthe interest ratebeing belowmarketrates.
Abelow-marketloanisgenerallyagiftordemand loanwheretheinterestrateislessthantheapplicablefederalrate(AFR).The tax codedefines theterm“giftloan”asanybelow-marketloanwheretheforgoingofinterestisinthenature ofagift,whilea“demandloan”isanyloanthatispayableinfullatanytime,at the lender’s demand.TheAFRisestablishedbytheTreasury Departmentandpostedmonthly. Asanexample,theAFRratesforOctober 2018were:
Borrower–IstreatedaspayinginterestattheAFRrateineffectwhentheloanwasmade. Theinterestisdeductiblefortaxpurposesifitotherwisequalifies.However,if the loanamountis$100,000orless,theamountoftheforgoneinterestdeductioncannot exceedtheborrower’snetinvestmentincomefortheyear.
Lender–Istreatedasgiftingtotheborrowertheamountoftheinterestbetweentheinterest actuallypaid,ifany,andtheAFRrate.Boththeinterestactuallypaidandtheforgone interestaretreatedasinvestmentinterest income.
Exception – Thebelow-marketloanrulesdonotapplytogiftloansdirectlybetweenindividualsif theloanamountis$10,000orless. Thisexceptiondoesnotapplytoanygiftloandirectlyattributabletothepurchaseorcarryingofincome-producing property.
Parent Transferring a Home’s Title to a Child – When an individual passes away, the fair market value (FMV) of all their assets is tallied up. If the value exceeds the lifetime estate tax exemption ($11,180,000 in 2018; about half that amount in 2017), then an estate tax return must be filed, which is rarely the case, given the generous amount of the exclusion. Because the FMV is used in determining the estate’s value, that same FMV, rather than the decedent’s basis, is the basis assigned to the decedent’s property that is inherited by the beneficiaries. The basis is the value from which gain or loss is measured, and if the date-of-death value is higher than the decedent’s basis was, this is often referred to as a step-up in basis.
If an individual gifts an asset to another person, the recipient generally receives it at the donor’s basis (no step-up in basis).
So, it is generally better for tax purposes to inherit an asset than to receive it as a gift.
Example: A parent owns a home worth (FMV) $350,000 that was originally purchased for $75,000. If the parent gifts the home to the child and the child sells the home for $350,000, the child will have a taxable gain of $275,000 ($350,000 − $75,000). However, if the child inherits the home, the child’s basis is the FMV at the date of the parent’s death. So in this case, if the date-of-death FMV is $350,000 and if the home is sold for $350,000, there will be no taxable gain.
This brings us to the issue at hand. Afrequentlyencounteredproblemiswhenanelderlyparentsignsthetitleofhisorherhomeoverto achildorotherbeneficiaryandcontinuestoresideinthehome.Tax law specifies that anindividualwhotransfers a titleandretainsthe righttoliveinahomefortheir lifetimehasestablishedadefactolifeestate.Assuch, whentheindividualdies, the home’s value is included in the decedent’s estate, and no gift tax return is applicable. As a result, the beneficiary’s basis would be the FMV at the date of the decedent’s death.
On the other hand, if the elderly parent does not continue to reside in the home after transferring the title, no life estate has been established, and as discussed earlier, the transfer becomes a gift, and the child’s (gift recipient’s) basis would be the parent’s basis in the home at the date of the gift. In addition, if the child were to sell the home, the home gain exclusion would not apply unless the child moves into the home and meets the two-out-of-five-years use and ownership tests.
Another frequently encountered situation is when the parent simply adds the child’s name to the title, while retaining a partial interest. If the home is subsequently sold, the parent, provided they met the two-out-of-five-years use and ownership rules, would be able to exclude $250,000 ($500,000 if the parent is married and filing a joint return) of his, her or their portion of the gain. A gift tax return would be required for the year the child’s name was included on the title, and the child’s basis would be the portion of the parent’s adjusted basis transferred to the child. As mentioned previously, the child would not be able to use the home gain exclusion unless the child occupied and owned the home for two of the five years preceding the sale.
These are only three examples of the tax complications that can occur in family transactions. I highly recommended that you contact this office before completing any family financial transaction. It is better to structure a transaction within the parameters of tax law in the first place than have to suffer unexpected consequences afterwards.