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Avoiding the Property Transfer Tax Trap

Paula Allgood
July 18, 2023

Suppose you own property you intend to transfer to your loved ones. Perhaps you are considering giving your children an ownership interest in your principal residence. But before you act, review the tax consequences of your decision as tax laws include provisions involving sales to related parties.

Tax Considerations for Transferring Property

As you might imagine, the IRS’s definition of a related party covers relatives like your children, grandchildren and siblings, but also applies to business entities you own. Here are several common situations you may encounter, and tips to help you avoid a tax surprise:

Installment sales. With an installment sale of investment or business real estate over two or more years, you can defer tax on your gain until the tax years in which payments are actually received. However, if you sell the property to a related party who disposes of it within two years, the remaining tax is due immediately.
Tip: To solve this problem, insert language in the sale or transfer agreement that does not allow the disposition of the property within two years.
Selling at a discount. If you’re selling a house to a related party, you may wish to give that person a sweetheart deal. Unfortunately, the IRS may reclassify the transaction as a gift if the property is sold at considerably less than its fair market value (FMV). Fortunately, you have some wiggle room. If you discount the sale by less than 25 percent, you should be okay.
Tip: Err on the side of safety by having an appraisal of the property before the transfer date OR build documentation that justifies the fair market value.
Transferring remainder interests. In some cases, you may wish to transfer an ownership interest in your home or your estate while continuing to live there. Although this may meet your estate planning objectives, the estate can’t take advantage of the $250,000 home sale exclusion of potential capital gains tax ($500,000 for joint filers). However, if your heirs subsequently meet the two-out-of-five-year ownership and use requirements, the exclusion becomes available once again.
Tip: Prior to transferring partial interest in your home to anyone (including a trust or an estate), understand the impact of this action on the tax-free home gain exclusion.
Like-kind exchanges. Taxable gains can be deferred when selling qualified real estate property. The tax is generally deferred until the replacement property is sold, but the tax law imposes a two-year holding requirement on the parties to a deal. Alternatively, you may qualify under a special exception, such as proving tax avoidance wasn’t the purpose of the sale.
Tip: Related property transactions of this type can get complicated. Ask for a review of your situation before trading any property and speak with an expert who handles these types of transactions.

As you can see, transferring property to family members can get complicated and cause undue tax obligations if not handled correctly. So seek advice long before transferring key assets.

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