5 Ways to Transfer a Home to Your Child
JD, LLM, CEPA | Senior Director of Wealth Planning
Homeownership is one of the most foundational aspects of the American dream—young adults often aspire to the idea of a home with a white picket fence. And today, young adults are exposed to a number of notions about housing, ranging from housing prices that make entering the market prohibitively expensive to extravagant multi-million-dollar homes as seen on social media. As is more often the case, young adults just beginning their careers or starting families will likely face challenges entering the housing market without help from family.
But instead of focusing on the homebuyer, we're going to focus on parents looking to transfer, gift or facilitate a home purchase for an adult child. Unfortunately, helping your child to get their first home is fraught with traps. Just making a purchase and handing them the title and keys can result in some significant unintended tax consequences.
For many parents or grandparents, helping an adult child attain their first home is important. Maybe parents want their children to be able to enjoy the benefits of a large house while their grandchildren are young. But typically, a couple can't afford a large house until their children are already grown and no longer need all that space.
Alternatively, parents may want to help the next generation start building equity. Helping young adults buy real property could give them a head start, especially in a highly appreciating market or a market that is already so appreciated that it's a barrier to entry for most young adults just starting out in their careers. In this article, we'll take a closer look at five methods to gift or transfer a home to your child.
1Outright gift or bequest
The most common way to transfer a home to your child is for them to inherit it after you pass away. There are some benefits to this method, especially the step-up in basis that occurs at death. If your child chooses to sell the home and buy another, the fair market value of the home is essentially the value at your passing or six months thereafter. Thus, there likely wouldn't be much capital gain on the sale if it occurs close to the time of the transfer. The downside to this method is your child must wait for you to die to get the home and as mentioned earlier, many parents may want their child to have a home of their own while they're still alive.
Parents can make an outright gift of a home to an adult child. Any gift that exceeds the annual exclusion of $16,000 will be subject to gift tax and require that a gift tax return be filed. Fortunately, the lifetime gift exemption amount is $12,060,000 per person, so most people will be able to utilize the exemption to shelter the gift of a home. In this scenario, a federal gift tax return Form 709 must still be filed.
There are some other tax issues to be aware of when making a gift. You should check your local law on property tax transfers. The ownership change from parent to child isn't exempt in every jurisdiction and if not, then the value of the home for property tax assessment may increase from what the parent was paying, possibly exceeding the child's budget. Also keep in mind that with a gift, the child has the same basis that the parent had in the property, so be sure to document all capital improvements that the parent made.
A parent can help a child attain a home by financing the purchase. By acting as the lender, the parent helps the child avoid the underwriting process with a third-party lender, especially if it's likely they would have a higher interest rate due to factors like a low credit score or low income.
For intrafamily loans not to be considered a gift, a parent must charge at least the minimum interest rate set monthly by the IRS, which is almost always lower than a conventional loan rate. In addition to providing a lower, more advantageous rate to the child, the minimum interest rate set by the IRS also avoids further charges such as private mortgage insurance.
When engaging in a business transaction within a family, the key to preventing unwanted surprises is documentation. The installment note should be in writing, signed by both the parent and child. It should detail not just the amount borrowed, but the length of the note, an interest rate at least as equal to the monthly IRS rate, and what would constitute a default and the resulting action to be taken. If the parent files a security interest on the note, then the interest payments are deductible to the child on their Federal Income Tax Form 1040, and interest is income to the parent.
Using the annual gift tax exclusion, the parent has the option to forgive a portion of the loan each year by making yearly gifts of $16,000. Gift amounts within the annual exclusion don't require a gift tax return to be filed.
Parents engage in a bargain sale of a home sometimes on purpose, usually by accident. A bargain sale occurs when you sell a home to your child for less than its full market value. An example would be if you sell a home worth $800,000 to your child for $500,000. The $300,000 difference is considered a gift. You may use your previously mentioned lifetime gift exemption that exceeds $12 million to shelter that $300,000, but you must still file a gift tax return.
There are also some income tax consequences. If the parents bought the home for less than full market value, such as in the situation where they've owned the home for some time, then their basis in the home will be split pro rata between the sale portion and the gift portion. When all is said and done, the parents may need to pay capital gains on the sale portion of the transaction. If in the prior example the basis is $400,000, then $250,000 of basis is allocated to the sale portion and $150,000 of basis is allocated to the gift portion. The parents sold $500,000 worth of house with $250,000 basis, resulting in $250,000 of capital gain, resulting in $250,000 of capital gain on which taxes would need to be paid. This gain can be sheltered by the home sale gain exclusion for people who owned and used their principal residence for two out of the five years before a sale—$250,000 per individual, $500,000 for married couples. This exemption wouldn't be available for vacation or rental property. The child's basis in the home is a combination of the sale portion ($500,000), plus the carryover basis from the gifted portion ($150,000) for a total of $650,000.
4Qualified personal residence trust
What if it's a vacation home you'd like to transfer or you'd like to continue to live in the home for a few more years before giving up the title to your child? Consider a qualified personal residence trust, or QPRT.
A QPRT allows you to place a home in a trust for a certain term of years. At the end of the term, the home passes to the named beneficiary, i.e., your child. You can live in the home during the trust term. It's important to outlive the trust, however, because if you die before the trust terminates then the whole transaction is ignored. The value of the gift of the home is reduced by the value of your right to continue to use it for the term of years. However, any gift value (of the remainder interest) can be offset by your lifetime exclusion.
As an example, let's consider a parent puts that same $800,000 home into a QPRT for ten years. The ability to live in the home for ten years equals $217,176. The remainder interest, or the value of the home going to an adult child at the end of 10 years is equal to $582,824. This latter amount is a taxable gift, which is offset using the lifetime gift exclusion. The annual gift exclusion is inapplicable to this transfer.
Be careful about transferring mortgaged property to a QPRT as it creates gift tax issues. It's recommended to transfer unleveraged property or consult a tax advisor before transferring a home with a debt obligation attached.
5Remainder purchase marital trust
This last method works quite well in blended family or second spouse situations. With a remainder purchase marital trust, or RPM trust, the grantor transfers a home to a trust and gives his spouse the right to live in the home for either a term of years or life. At the same time, the grantor sells the remainder interest to a trust for his children. If the children can't afford to purchase the remainder interest in the home, then this part of the transfer will be considered a gift and uses the grantor's lifetime gift exemption. The portion allowing the spouse to live in the home qualifies for the gift tax marital deduction without incurring estate tax at the spouse's death, since the remainder interest was already sold away. At the end of the term or stated life, the home passes to the grantor's children (outright or in trust) free of gift or estate taxes. The home is not included in the grantor's estate. The RPM trust has an advantage over the QPRT as there's no risk of the grantor dying during the trust term and undoing the transaction.
In an RPM trust, the grantor can use the home along with the spouse but if they divorce, then this would cause a problem as the spouse would still retain the right to use the home until the stated term ends. An additional caveat is to check local property transfer rules as the transfer may be considered a change of ownership that triggers a tax value reassessment. While an RPM trust works well with a home, it can be used with any type of property, such as investible assets. For example, instead of living in the home, the spouse would receive an income interest or annuity during the stated term.
Understanding your options
Some of the methods laid out above may lead you to want to just put your adult child's name on your home's title for simplicity's sake. But be aware of emptor of joint title issues. When you include your adult child on the title to your home, you've now exposed your home to your child's creditors. Your child must also sign off on any decisions you make regarding your home such as refinancing, a line of credit or a sale. The addition to the title may be considered a gift, and if you sell the home you may have to share the capital gain exemption with your child, too.
In conclusion, there are several ways to transfer a home to your child. Each has its share of federal transfer, income and local property tax issues, and considerations, so it's important to consult with your tax advisor before executing any one of them.
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