Question: Dear Mr. Pancheri, I read your great article “Gifting Real Estate Under the Annual Gift Tax Exclusion.” In this article you explain that an LLC can be used to accomplish this. I am considering an LLC as a method to gift my house to my son. I have two questions:
- Is there any change in the basis when membership units are transferred (that is, can I take advantage of the Capital Gains exclusion)? Question: Dear Mr. Pancheri, I read your great article “Gifting Real Estate Under the Annual Gift Tax E -Can property taxes continue to be used as an income tax deduction when property is in an LLC?
I appreciate your help. Thanks. E.R.
Answer: Dear E.R. - You ask some very good questions that need to be addressed before you start giving away your home, whether through an LLC or otherwise.
First, let’s step back a bit and consider the consequences of selling your home outright to a third party rather than gifting it to your son. Under §121 of the Internal Revenue Code, you can exclude up to $250,000 of gain realized from the sale or exchange of your personal residence if you owned and used the property as your personal residence for at least two years during the five-year period ending on the date of the sale or exchange. This can be an important tax benefit if you meet the requirements and your personal residence has appreciated considerably in value. For example, if you purchased your home for $300,000 and then sold it for $550,000, your gain of $250,000 would normally be subject to a tax of around $37,500. However, under I.R.C. §121, this tax is avoided on the sale of a personal residence.
If you give your house to your son instead of selling it to a third party, the tax consequences are different. By gifting it to your son, you will avoid the capital gains tax. That’s because a gift is not a sale or exchange of the property. In that case, your son would step into your shoes and assume your tax basis (i.e., $300,000 from our hypothetical above). If he later sells your home, he would pay a capital gains tax on the difference between the sales price and his $300,000 basis. Of course, if he meets the requirements of I.R.C. §121, he would be able to avoid the capital gains tax on the first $250,000 ($500,000 if he's married) of appreciated value as well.
Now let's consider the estate-tax benefits of gifting your home to your son rather than selling it. Let's assume that your overall estate is currently valued at more than $2 million ($4 million if you’re married). In that case, if you simply deeded your home over to your son, you would pay no income taxes or gift taxes on the transfer. However, to eliminate the gift tax, you would have to use a portion of your unified credit against the gift and estate tax.
So, what's the benefit of gifting your home to your son now instead of giving it to him upon your death? By giving it to him now, you avoid the estate tax on the value of the appreciation of your home from the time of the gift to the date of your death. That could be significant in view of rapidly increasing property values. For example, if your home increases in value from $550,000 to $1 million from now until you die, then you will have avoided the estate tax on $450,000 - a tax of approximately $207,000 under current estate tax laws.
But, wouldn't it be better if you could eliminate the estate tax on the entire value of your home - not just the future appreciation? In my article, entitled "Gifting Real Estate Under the Annual Gift Tax Exclusion," I discussed the use of an LLC to do just that, by bringing the entire gift under the annual gift tax exclusion (currently $12,000 per year per recipient). That would not only avoid the estate tax on the appreciation in value, it would also exempt the current value from the estate tax simply because you wouldn't have to use any of your unified credit in the process. In our hypothetical, the net estate tax savings wouldn't be just $207,000 (the tax on the appreciated value), it would be roughly $460,000 (the tax on the $1 million date-of-death value.
The technique is quite simple. In order to give your home away in increments that are valued at less than the annual gift tax exclusion (currently $12,000 per year), you would transfer your home to an LLC in exchange for 100% of the membership units. It’s important that you create enough membership units in the LLC so that the value of each unit is somewhat less than the amount of the annual gift tax exclusion. Then you can give your son one membership unit each year without having to pay a gift tax or use any of your unified credit against gift or estate taxes. Over a period of time, your house will be transferred entirely to your son without any gift or estate taxes. Of course, the article also discussed ways to accelerate this whole process by having your spouse elect to join in on the gift, and by making gifts to your son’s spouse and/or children.
Now that we’ve put all this into perspective, let’s tackle your specific questions. You asked, first, whether there is any change in the basis when membership units in the LLC are transferred to your son and/or others? Under current income tax laws, if you transfer your home to an LLC in exchange for 100% of the membership units, no gain or loss is recognized. The value of your membership units is assumed to be equal to the value of the property transferred (i.e., your home, in this case), and your tax basis in the membership units is deemed to be equal to your tax basis in your home immediately prior to the transfer. In our hypothetical, the value of your home was assumed to be $550,000 and your tax basis was assumed to be $300,000. Following the transfer, the value of your membership interests in the LLC is assumed to be $550,000 and your tax basis in the membership units is assumed to be $300,000. If you received more than one membership unit in the LLC at the time of the transfer (which you should in order to bring the value of each unit to less than $12,000), then your tax basis in each membership unit would be equal to your basis in the property transferred divided by the number of membership units you received. Assuming you received 47 membership units following the transfer, your tax basis in each unit would be $6,383.
If you then starting gifting membership units to your son, each membership unit that your son received would carry a tax basis equal to your tax basis in that unit (i.e., $6,383 in our hypothetical). If your son later sold one or more of his membership units, then he would incur a capital gains tax on the difference between the sale price and his tax basis of $6,383.
You also asked whether you could take advantage of the Capital Gains exclusion under I.R.C. §121 if you transferred your home to an LLC. The IRS has generally treated single member LLCs as disregarded entities, which means that if you transfer your home to an LLC and take back all the membership units, you’ll still be eligible for the capital gains exclusion if the LLC then sells the home.
However, if you transfer one or more membership units to another person (i.e., your son) while the LLC still owns the home, then the LLC will be converted from a disregarded entity to a partnership for tax purposes. In that case, it appears that you will lose the capital gains exclusion if the LLC then sells the home while you still own some of the membership units. In that case, the LLC would have to file a partnership tax return, and the net profits would then be taxed to you and your son in proportion to your membership interests.
Incidentally, any real estate taxes paid by the LLC would be fully deductible for tax purposes. If you’re the sole member, then the tax deduction would be claimed on Schedule A of your Form 1040. If you’re not the sole member, then the taxes paid would reduce the net profits on the LLC’s partnership return, and the resulting taxable gain reportable by you would be reduced accordingly.
While the loss of the Capital Gains exclusion may seem to be a deal breaker, it really shouldn’t be. If your estate is large enough to be subject to a federal estate tax, then the estate tax savings will far out weigh any loss of the capital gains tax exclusion. Moreover, if your son owns the house and lives in it for two years, he will be able to use the exclusion himself. In that case, you won't have lost the exclusion, you'll just have shifted it to your son.