How does grandma pass along the country house?
Objectives: share the value of a property, avoid taxes and avoid family quarrels.
“My mother-in-law is 94 years old. She owns a house in Vermont, valued at $700,000. His will leaves everything to be shared equally between his two children: my wife and my wife’s brother.
“The brother offered to give my wife a check for $350,000 for her share in the house so he could move in now. My mother-in-law would then rewrite her will to leave the house to the brother with the rest of the shared estate.
“What are the tax consequences? Perhaps the brother could split the payment to take advantage of the annual $16,000 gift tax exclusion? »
Dan, New Jersey
You juggle two ambitious goals: avoiding taxes and avoiding family discord. These goals can conflict. Let’s see if we can reconcile them.
I confess that the abbreviated version of your query posted above does not do full justice to the situation. The omitted details make it clear that you have not only a proposed real estate transaction at stake, but a lot of emotional baggage. Some in-laws don’t get along with some others. The uneven disposition years ago by the family patriarch of a valuable business asset left resentments in its wake that still simmer.
Even when everyone gets along, it’s not easy to happily have a family vacation home that has both a high price tag and powerful childhood memories attached to it.
There’s not much I can do when it comes to family counseling, but I can weigh in on structuring an asset transfer. I think your relatives’ idea of how to go about it is far-fetched.
To make this story easier to follow, I’m going to invent a few names. Let’s call your wife Jill, her brother Jack, and their mother M. I assume M is single and uses the house at least part of the year.
Just write a check? It’s terribly confident. What if M rewrote her will to leave the house to charity? Or, what if, when M dies, Jill refuses to give up her half of the house?
Suppose, instead, that M hands over ownership to Jack and Jill at this time, perhaps retaining a limited right to use part of it as long as she lives. Now Jack offers Jill $350,000 for her half. This eliminates the risk of someone pulling the rug out from under Jack’s foot. But this creates tax problems.
M is expected to file a Form 709 disclosing two gifts of $350,000. Of course, a gift is no worse than a bequest when it comes to transfer taxes, but there is another problem: capital gains tax.
Let’s say the family acquired the country home decades ago for $70,000 and invested $50,000 in improvements. That would make a cost base of $120,000, or $60,000 for each half. This base is passed on to Jack and Jill when they receive the gift. When Jill sells to Jack, she will have to declare a gain of $290,000, and since the house is not her principal residence, she will not be entitled to any home sale exclusions.
Here’s a better solution: Jack rents the house with an option to buy. When M dies, he exercises the option.
As long as M is still the owner when he dies, the cost basis is grossed up and the family has no taxable gain to declare. Jill would receive money for her half when the estate was settled. But if Jack is confident he’ll ever exercise the option, he might move in now and even be comfortable investing the money in upgrades.
It is important to structure option and lease contracts so that the IRS cannot report the transaction as a disguised sale. I would recommend contractual provisions like these:
“A payment from Jack to M for the option, maybe $7,000. It would be ordinary taxable income for M only if and when the option expires unexercised, an unlikely outcome.
—An exercise price close to the appraised value of $700,000.
—An escalator, such as 3% per annum. So if M died at age 98, the price would be $784,000 and Jack would give Jill a check for $392,000 to settle that part of the estate.
—Low but defensible rent, like $21,000 a year. M would have to report this as rental income, but she could deduct property taxes, maintenance, insurance, and depreciation on a 27.5-year schedule. (With a base cost of $120,000, the depreciation would be $4,364 per year.) She would probably have no net income to report. Laddering at death would eliminate the potentially taxable recapture of amortization.
— Transferability of the option and the lease. So if Jack dies before exercising the option, his widow or children could step into his shoes.
It would be a good idea for Jill to agree in writing to the lease and the option.
My advice to you, Dan, is to be careful not to get too involved in the negotiations between your in-laws. But you could push Jill and Jack to make a deal on their own, then head with their mom to a Vermont attorney’s office.
Do you have a personal finance puzzle that might be worth a look? These may include, for example, lump sum retirement payments, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate useful analysis.
Letters will be edited for clarity and conciseness; only some will be selected; the answers are intended to be educational and are not a substitute for professional advice.
More in the Reader Asks series:
What is the risk that I will be doubled if I delay social security?
Should I pay off my mortgage?
Directory of Reader Asks Columns