Gifting equity in a home

Preserving family tradition and effective tax planning may not often intersect. When parents gift a home with equity to their children, however, they may be able to accomplish both preservation of the home for future generations and potential tax savings by moving a valuable asset out of the estate.

Consider a scenario where parents own a home valued at $1 million and intend to include it as part of their estate. If the home continues to grow in value — for example, from $1 million to $2 million over the parents’ remaining lives — that $2 million figure would increase the likelihood that the value of the parents’ estate would exceed the estate tax exclusion.¹

Potential tax implications

As parents make their estate plans, it’s important to stay on top of lifetime gifting — the IRS sets rules and limits around gifts to individuals, and if gifts go over that limit, the recipient may have to pay taxes on the amount over the limit. For example, each parent can give each child up to $17,000 per year in 2023 without the gift counting against their lifetime exclusion. Amounts over that will be debited against the federal gift and estate tax exclusion limit.

“With potential changes in the gift and estate tax rules in 2026 [when exclusion limits are set to drop to pre-2018 levels], many parents may consider substantial gifts to their children before then, as they may not have the full $12.92 million available for future gifts,” says Greg Miller, senior wealth planner with Wells Fargo Wealth & Investment Management.

However, there are other tax consequences to consider. If parents gift a home with equity today, the children take the parents’ original tax cost basis (plus any capital improvements). While a lifetime gift transfers equity to the children sooner, it may expose them to larger capital gains taxes in the future.

If the house were instead passed to children as part of an estate, the children would receive a “stepped-up” basis, resetting the tax cost basis at the market value on the date of the second parent’s death. That means the children would likely pay less capital gains tax when the house is eventually sold than they would if the house were gifted by their parents.

“There’s always a trade-off between avoiding estate taxes and having to pay capital gains taxes,” Miller says. “Currently, the top federal estate tax rate is 40%. Depending on where you live, the capital gains rate can be more substantial.”

What if the parents pay the mortgage first?

If they have the money to do so, parents may choose to pay off the mortgage before gifting a home with equity.

Doing so could make it easier for the parents if they want to give the home to more than one child — it might eliminate some confusion over which child owns what. If the mortgage is paid off, the shared gift can create a tenancy-in-common situation where the children share ownership and management of the property. Before going this route, it’s a good idea for the parents to discuss the arrangement and responsibilities with their children, as well as their tax, legal, and financial professionals. Such arrangements should be thoroughly discussed among the parties involved.

Some parents may want to use the home to help their children develop a sense of financial responsibility — for example, by essentially becoming a mortgage lender for part of the home’s value and requiring the children to pay for that portion of the home’s value. Since this likely would be taxed as a sale of the property to the extent of the mortgage, parents should discuss any potential capital gains issues with their tax advisor first.

What if the parents do not pay the mortgage first?

Another option is for children to assume the mortgage with the gifted home. The IRS considers this as the parents accepting a partial payment for the property.

“The transaction could be considered part-gift/part-sale,” Miller explains. “A $1 million house with a $300,000 mortgage, for example, is considered a gift of $700,000.”

An important aspect to consider: If the children want to take over the mortgage, they will need to get approval from the lender. If the children have bad credit or other obstacles that would prevent them from getting a mortgage on their own, this might cause a problem with the existing lender.

Can the parents stay in the home after gifting it?

Parents can also choose to place the home into a Qualified Personal Residence Trust with the children as beneficiaries. Doing so gives parents the right to live in the home for a stated term — 15 years, for example. The value of the reported gift is measured at the time the home is gifted into the trust, not when the children move in years later. That could benefit the children if the home appreciates in value significantly before they take ownership of it.

“Even if the house triples in value, it’s out of the estate and there’s no further gift amount applied to the lifetime exclusion,” Miller says. “However, if the parents do not survive the term of the trust, the estate is taxed as if they never made the gift.”

Next steps

The estate and gift tax exclusions are subject to a cut in 2026. Be sure to stay connected with your financial professionals and legal and tax advisors.

“With so many complex factors at play, it is important to understand both family and tax implications of your gifting strategy,” says Miller. “Your advisors with Wells Fargo Wealth & Investment Management can work with you and your legal and tax advisors to work through the dynamics to determine a path for gifting your home and other assets.”

 

 

1. The estate/gift exclusion and generation-skipping transfer (GST) exemption are currently slated to increase by a cost-of-living adjustment every year but are subject to a cut in 2026. As of May 16, 2023, the estate tax and GST lifetime exemption is $12.92 million per taxpayer and the gift tax annual exclusion is $17,000. https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes