What Are the Tax Considerations When Parents Transfer a Home to Children? In Yorktown Heights, New York
When you inherit a home from your parents, there are several tax issues that need to be addressed. They differ by state. You’ll need to understand the details, so you don’t end up with a tax surprise.
When a home is transferred from a parent to a child, there is no property tax reassessment, if this takes place in California. This can lead to challenges figuring out the difference between property tax base and cost basis. This is clarified in a recent article from the San Francisco Chronicle, “Taxes on a home can be confusing: Here’s how to keep them straight.”
If parents transfer their home to a child, the child can keep the current assessed value and annual property tax. The transfer can be either while the parents are living or in their will. If the transfer is an inheritance, and the child keeps the low property tax base, the child will still receive the stepped-up basis and avoid a substantial capital gain, when the home is eventually sold.
In other words, if parents give their home to their child as an inheritance, can the child have both the continued low property tax and the stepped-up basis? Yes, provided the property is transferred at the parent’s death. If it’s transferred while the parent is still alive, the child will receive the property tax break. However, he or she will not get the step-up in basis, which is a huge tax break for highly appreciated homes.
People frequently confuse “property tax base” and “cost basis,” and property taxes with income taxes. They’re entirely separate systems. Property taxes are governed by state law. Cost basis, capital gains and the step-up in basis are part of the income tax system. For example, in California, your property tax base (known as your “assessment”) is generally what you paid for your house, plus an inflation factor not to exceed 2% a year, plus the value of major improvements. When property changes hands in California, it’s typically reassessed at current market value, which can mean a big spike in property taxes. As you can imagine, California home prices have generally increased much more than 2% a year over long periods.
Proposition 58 allows parents and children to transfer a primary residence, as well as a large amount of other property, between each other without any property-tax. This transfer can be by gift, sale or inheritance. This tax break is usually used, when a parent dies and leaves a home to a child or children. However, parents can also transfer the home, while they’re still alive without requiring a reassessment. The child can later transfer the inherited home, and its low property tax base, to their children.
Under the income tax system, the cost basis in your home (if you’ve never rented it out) is generally what you paid for it, plus the cost of major improvements. If you sell your home for more than its cost basis, the profit is taxed as a capital gain. If you’ve used the home as your primary residence for at least two of the past five years ending on the sale date, the first $250,000 in capital gains, or $500,000 for married couples, is tax free. If you retain your home until death, your heirs could receive an even greater capital gains tax break.
When you pass away with appreciated assets, including a home, their cost basis is “stepped up” to the market value on your date of death. Your heirs inherit the assets with their new, stepped-up cost basis. This will eliminate any taxes on the appreciation that happened in your lifetime. If your heirs sold these assets immediately, they’d owe little or no capital gains tax.
Unlike the property tax break, this capital gains tax break is only for inherited property. If you give your home to a child while you’re still alive, the child takes over your cost basis and loses the stepped-up basis. In addition, if you give your child all or part of the home while you’re alive, you’ll have to file a gift-tax return for the value that exceeds the annual gift tax exclusion. Although you probably won’t owe gift tax on the home’s value, it will be subtracted from your combined lifetime gift and estate tax exemption, which is $11.18 million for any person who dies in 2018, or $22.36 million for a couple.
If a married couple owns a home together as community property, and one spouse dies, the entire house is stepped-up to the date of death value. After the surviving spouse dies, it’s stepped up again.
Hypothetically, you could use the $250,000/$500,000 capital gains tax exclusion on a primary residence use every two years. There is no limit, provided you’ve lived in the home at least two of the past five years. However, there’s an exception if you bought the house as part of a 1031 exchange. That’s a federal law that allows you defer the tax due on the sale of business or investment property, if you reinvest the proceeds in another property. If the house is acquired through a 1031 exchange and you convert rental property to a primary residence, you have to live in it two of the last five years, but also own it for the last five years.
If you give a home to your children, they can use this exclusion, if they meet the primary-residence requirement. This is entirely different than a property tax break, which you can use only once. California homeowners 55 and older can sell their primary residence and transfer their property tax assessment to a replacement home of equal or lesser value. The replacement home must be in the same county as the old one (or in one of the 11 counties that accept incoming transfers). Homeowners, including their spouse, if married, can only do this once in a lifetime. This transfer doesn’t impact your cost basis or capital gains.
There’s an interesting new law being proposed in California, which appears on the November ballot. Proposition 5 would allow seniors to transfer their property tax base to a replacement home, regardless of the price and located anywhere in California, as many times as they want. If they bought a home that cost less, their assessment would be reduced, and if they buy a pricier home, the difference in the price between the old and new homes would be added to the old home’s assessment.
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