My friend and her parents want to create new living space in their huge detached garage (i.e. turn it into a 3/1.5 house), move into it, rehab their house, and then rent it out.
They were considering between taking a HELOC or refinancing with cash out. But today a new idea came up. Her parents have been stressed over the mortgage, even though they have over 50% equity in the home. So we thought perhaps a straight purchase of the home might be the best option.
She wants to purchase the house (through conventional financing) at the price of her parents' mortgage, then get extra cash out to do the construction/rehab work. But I just heard today that this might be considered a gift, and that she might be heavily taxed on it. Is this true?
@Nghi Le Most likely the 50% equity amount would be considered a gift. The IRS will consider something sold at below value to family to be a gift that may result in a gift tax. The receiver doesn't pay the tax the giver does.
The question will be what is the lowest value of the home and how does that relate to the amount she is going to buy it for? Each year a person can give roughly $15k (you would need to confirm exact amount since it is adjusted most years) to a person without being required to report it. This means that her father and mother could give her a combined $30k gift ($15k each) each year without triggering gift taxes. If needed they could do the transfer in stages say 25% equity in Dec and 25% in January for $60k transferred in a couple months.
There is also a lifetime gift allowance of several hundred thousand dollars that could be used which is separate from the annual gift limits. This is basically pregiving their estate so could mess up estate planning if not used correctly. She and her parents really need to talk to a CPA about what the best options are and what tax conciquences could come up.
@Paul Ewing is right in his statement that the equity will likely be classified as a gift by the parents to the daughter. A gift is any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return. Since the daughter is not buying the house at market value, the difference will be a gift.
The current annual gift exclusion is $14,000. Bother parents can use their exclusion, as Paul mentioned, to bring the total annual exclusion to $28,000. The exclusion means you don't have to worry about that portion of the gift being subject to tax. Example: you have a $40,000 gift; only $12,000 (40,000 - 28,000) is subject to tax if both donors (parents in this case) use their exclusion.
It is important to note that the lifetime gift exclusion for an individual is $5.34 Million, meaning an individual can gift that much in a lifetime without being taxed. Married individuals can combine this for a total $10.68 Million in lifetime gift exclusions. When individuals exceed their annual exclusions (of $14,000), the excess that was gifted will be applied to the lifetime gift exclusion and decrease it. So if you were to gift someone $1,014,000, your annual exclusion would be taken out of the gift leaving you with $1 Million. The $1 Million would be applied to your lifetime exclusion of $5.34, leaving you with $4.34 left to gift tax-free. So even though you gifted someone a huge chunk of change, you don't pay taxes on it since you had your lifetime exclusion available for use.
I don't know the financial situation of your friend and her parents, but unless she is dealing with a multi-million dollar property, her parents likely won't need to worry about paying gift tax currently.
You guys are extremely awesome and helpful! Thank you so much!
The mortgage on the house is $90k, and the house is valued somewhere between $180k and $200k. Her parents also fall in between the low and middle income bracket. From what it sounds like, both my friend and her parents won't have to worry about being taxed because of their lifetime exclusion, so she can go ahead and make the purchase?
Also, is this the same for non-family purchases? Since investors buy houses at a discount, the homeowner doesn't get charged on that "gift", right?
@Nghi Le I'm not going to comment on whether she can "go ahead and make the purchase," but from a gift tax perspective, unless her parents have already gifted their annual exclusion, gift tax will be a non-issue.
The difference between non-family purchases is that they are done at "arms length" meaning that the purchaser and seller do not share an interest of any kind. If the transaction is completed at arms length, it is assumed that market efficiencies drove the price and therefor gift tax will be a non-issue.
It is important to note that two non-family members can still have a shared interest through company ownership, contracts, etc. and if these people were to buy and sell to each other, it would not be an arms length transaction and gift tax would then be a factor.
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