Capital Gains Tax Trap for Generous Parents

Vested Partners A Multi-Family Office Blog

Well-meaning, generous parents can create capital gains tax problems by making certain types of gifts

Recently we met with a new client to discuss a gift of real estate from a parent to his daughter.  The property was purchased by the grandfather in 1970, and passed to the father in the 1990’s by deed of gift.  Father now proposes to deed the property to his daughter and her husband.

Two immediate issues came to mind.  Taxes and divorce.

First, if dad deeds the property to his daughter now instead of letting it pass to her after his death under the terms of his will, his daughter will take her father’s tax basis in the property.  In tax lingo, that’s called a “carryover basis.”  Since the property was originally purchased in 1970, then passed to dad by lifetime gift, dad’s basis in the property is the value of the real estate in 1970.  That means if he gives it to daughter now, her basis in the property will also be the 1970 value.  If she sells it, she will pay capital gains tax on the difference between the sales price and the value of the real estate in 1970.  Yikes.

How to address this?  If dad waits and leaves the property to his daughter in his will or trust, daughter will get a step up in the basis to the value of the property on the date of dad’s death.  Or, dad could also transfer the property to his daughter and retain a life estate.  If dad has a life estate, it means he is still an owner of the property, but all of his rights are extinguished when he dies, and daughter becomes the sole owner.  The IRS permits a step up in the basis of property when the life estate owner dies because the life estate owner retained a certain amount of control and ownership of the property during his lifetime.

The other issue that I addressed was whether dad should deed the property to daughter and husband or just to daughter.  In Virginia, a gift to a person remains that person’s separate property in the context of family law (ie. divorce).  Therefore, if dad deeds the property to daughter only, the property is not subject to division (sharing with husband) in the event of divorce.  We strongly recommend that when a person receives a gift or inheritance, that they not add their spouse to the title of the property – whether it’s real estate or cash in the bank or investments.  The best way to proceed is to make the gift to the daughter only.



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