With today’s home prices and the crazy real estate market, it’s likely difficult for your children to buy a home. And it’s conceivable that you are ready to move on from your existing home.

If this is true, consider the three options below.

Option 1: Make an Outright Gift

Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid!

Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.

If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.

If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.

If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.

Option 2: Arrange a Bargain Sale

Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.

Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.

Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you die. In these scenarios, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.

Option 3: Arrange Full-Price Sale with Seller Financing from You

The idea of giving your child a free house might be unappealing to you. Very well.

Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price. Your gain on the home will likely be tax free thanks to the principal residence gain exclusion granting up to $250,000 in tax free gain for single filers, or $500,000 in tax free gain for those filing married filing jointly so long as you and/or your spouse had owned and used the property as your principal residence for at least 24 months (2 years) out of the last 5 years leading up to the date of sale (date of the closing).

Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).

AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In July 2022, the long-term AFR, for loans of more than nine years, is only 3.22 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 2.99 percent (assuming annual compounding).

As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.5 percent, while the rate for a 15-year loan was around 5.4 percent.

So, for a loan made in July 2022, you could take back a 30-year note that charges the long-term AFR of only 3.22 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 2.99 percent.

Either arrangement would be a money-saving deal for your child, and you! It would allow you to defer any further gain surpassing the allowed $250K/$500K principal residence gain exclusion, since it would be classified as an installment sale, and recognize the gain across the term of the loan. Installment sales can also save you as the seller additional money if the income from the sale would put you in a higher tax bracket if it was ALL received in one year. This is especially important for high income sellers who could be subject to net investment income tax (3.8% tax). Single taxpayers with an adjusted gross income (AGI) over $200,000, and those married filing jointly that have an AGI over $250,000, are subject to this tax. Depending on the AGI, those taxpayers could end up paying 18.8% or 23.8% capital gains tax on their gain from the sale of their primary residence instead of 15% or 20%. The key to avoiding this tax is to keep your AGI below these threshold levels. Using an installment sale can help you achieve this.

For Example: Jan sells her rental house to Eric for $200,000. Eric pays Jan a $20,000 down payment and agrees to pay the remainder in equal $20,000 installments over the next nine years, plus 5% interest. Jan paid $80,000 for the house and owns it free and clear; so her total gain is $200,000 – $80,000 = $120,000. This means that 60% of each payment represents gain from the sale, and the other 40% is return of Jan’s basis. When Jan receives her annual $20,000 payments from Eric she’ll have to pay capital gains tax on $12,000. She’ll also have to pay tax at ordinary income rates on the $10,000 in interest she receives each year, and if you are near retirement, or in retirement you are likely at a lower income tax bracket, which means that ordinary income will be taxed at lower rates, not subject to Social Security or Medicare tax (15.3%), and the payments could give you sustainable cashflow for the term of the loan.

If you need any help regarding these issues Corridor Consulting would love to help, please schedule an individual consultation here. We’re looking forward to opening many more doors for you!

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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed