As people get older, it is not uncommon to gift their homes to their children or other family members. While the kind gesture is sure to be appreciated, there are some tax implications for the gift recipient.
If they decide to sell the gifted property, they will generally be responsible for paying capital gains tax on the proceeds. Many people are not prepared for this, and the amounts can be substantial in some cases.
As a result, when selling gifted property, it is crucial to be aware of the tax implications and do your calculations beforehand. Read on to learn more about capital gains on gifted property, how they work, and what to expect.
What is Capital Gains Tax?
Before diving too deep, let’s take a closer look at capital gains tax in general. Capital gains tax is a tax on the profit realized when an asset is sold. In other words, you won’t be responsible for any capital gains taxes if you hold onto the asset, even if the value goes up during the period. If, however, you decide to sell, you will have to pay taxes on the gains.
Capital gains are often realized when you sell stocks or bonds for a profit, but it also applies to the sale of property, precious metals, and more. Depending on your income, rates for the capital gains tax are 0%, 15%, or 20%.
In 2022, if you earn less than $41,675, you will not have to pay capital gains tax. If you make more than that, you will have to pay capital gains tax based on the 15% rate. But if you earn more than $459,750, the capital gains tax will increase to 20%. The table below highlights the capital gains tax rates for the year 2022.
Long-Term Capital Gains Tax Rates
| Tax Filing Status | 0% Rate | 15% Rate | 20% Rate |
| Single | $0 – $41,675 | $41,676 – $459,750 | $459,751 and more |
| Married, Filed Jointly | $0 – $83,350 | $83,351 – $517,200 | $517,201 and more |
| Married, Filed Separately | $0- $41,675 | $41,676 – $258,600 | $258,601 and more |
| Head of Household | $0 – $55,800 | $55,801 – $488,500 | $488,501 and more |
However, if you sell the gifted real estate after holding it for less than a year, you will be responsible for paying short-term capital gains tax, which is equal to your regular income tax rate for the given year.
How to Calculate Capital Gains Tax on Gifted Property
While capital gains tax can apply to many different items and investments, this guide looks specifically at how the tax is calculated for the sale of gifted real estate property.
To calculate how much tax you owe, the first step is to figure out the cost basis of the property and the fair market value. If someone gifts you a home while they are alive, your cost basis will be the amount the original owner paid for the property, plus any adjustments such as renovations or improvements.
For example, let’s say your parents gift you a $500,000 worth of home now that they bought for $150,000 and put $50,000 into improvements over the years. The cost basis for the property will be $200,000. The $300,000 difference between the cost basis and the property’s fair market value will be subject to the capital gains tax.
(2) Improvements over the years = $50,000
(3) Total cost basis = (1) + (2) = $200,000
(4) Fair market value = $500,000
(5) Capital gains subject to tax = (4) – (3) = $300,000
However, if the parents wait to transfer their home as a part of their estate plan after their death, you will be required to pay much less (if any) capital gains tax, and this is because of the stepped-up basis. Stepped-up basis is a tax policy that applies to estate transfers. It allows the person inheriting the asset to use the fair market value of the property on the date of the transfer. In other words, this essentially “steps up” the cost basis of a home or other asset to what it was worth when the original owner died.
So if your parents give you the same $500,000 home as a part of their estate when they pass, the cost basis would be the amount that the home was deemed worth on the date of their death, which will be much closer to that $500,000 value. This means you would pay far less in capital gains tax.
If your cost and tax basis are close to the home’s fair market value, you will have minimal capital gains taxes to pay. On the other hand, if your cost basis is much lower than the fair market value, you will generally have to pay much more in capital gains tax when you sell the home.
How is Fair Market Value (FMV) Determined?
It’s important to understand “fair market value (FMV)” as it is what the IRS will use to determine the taxes you pay when selling gifted property. The higher the difference between your cost basis and the FMV of a home, the more you will pay in taxes.
According to the IRS, FMV is essentially the price a property will sell for on the open market. It is the amount that an educated and unpressured buyer would pay for a home and still feel like they are working in their own best interest. The FMV can be subjective and may change frequently, and it is often up to an appraiser or assessor to set the value for a property.
But how is the actual value determined? Well, it often comes down to the condition of the home. A home with lots of problems will be valued less than one that is pristine. The use of comparables can also be necessary when determining the FMV of the property. Comparable homes allow you to get a better sense of what the home would sell for. In addition, things like the market, the time of year, and the overall trends in real estate can all impact the fair market value.
Tips to Reduce Capital Gains Tax When Selling Gifted Property
Now that you know a little more about capital gains tax on gifted property and how to calculate it, let’s discuss ways to reduce the amount you will need to pay. First of all, if you live in the home first, you can significantly reduce the amount of capital gains tax you need to pay.
If the home is used as your primary residence for at least two years in a five-year period before you sell it, you can exclude $250,000 in gains (or $500,000 if you are married). In many cases, this is enough to eliminate any capital gains tax.
Next, you can consider a 1031 exchange if the property gifted to you is a rental property. A 1031 exchange allows you to defer capital gains if you sell a rental property and replace it with another within six months. This will enable you to avoid paying capital gains tax until you sell the second home.
Of course, as we mentioned earlier, a property inherited after the original owner’s death is much more tax-friendly than one gifted when the owner is still alive. If you have any capital losses due to other properties or investments, these can often be subtracted from your capital gains to reduce the taxes you need to pay.
Final Thoughts
In conclusion, we hope that this guide has helped you learn a little more about how capital gains taxes work on gifted real estate properties and what you should expect. The amount you’re responsible for can be large, but it is certainly more manageable if you plan for it and find ways to reduce it.
