When I see people, especially older folks, selling their real estate holdings so they can give the revenues to their children, it makes me sad because I know that by selling, they are inadvertently giving much of their money to Uncle Sam. If you own a property, it is best to bequeath it to your children. Let them sell it after you’re gone.
For tax purposes, real estate value is based on the acquisition cost of the property plus capital improvements minus depreciation. This is called the tax basis. Usually, when ownership changes hands the tax basis is reassessed, and if the value increases (as it almost always does), Uncle Sam expects his share in the form of capital gains tax.
Just so you know, the tax basis is divided between the raw land and any improvements (structures, landscaping, etc.). Because raw land isn’t depreciable, it is in the property owner’s best interest to assure the land/improvement split is favorable: that the land value is low, and the improvement value is high. (You can read my column on Land v. Improvements for more on that.)
One of the ways to avoid paying capital gains tax is by transferring your property to a child or spouse upon your demise. For income tax purposes, the property’s tax basis is stepped up to current market value, but your beneficiaries do not have to pay capital gains tax. For example, if you bought an investment property for $150,000 twenty years ago and depreciated $100,000, the remaining basis would be $50,000. If you then sold the property for $700,000, your profit of $650,000 would be subject to capital gains tax amounting to approximately $215,000.
If instead, you held onto the property and left it to your children, when you passed away, their new tax basis would be the fair market value of $700,000. They could then sell the property for $700,000 and pay zero capital gains tax.
Here’s another example. I own a house that I purchased in 1973 for $15,000, which has since depreciated to $5,000. Its current market value is $350,000. If I sold it today, I would pay capital gains tax on $345,000 of profit, amounting to approximately $115,000. The kicker is that I have refinanced the property several times and I currently owe $260,000 on it. If I sold the property for its current market value, I would have to pay the capital gains tax plus recapture tax plus California income tax, leaving me with $235,000 in cash minus the $260,000 I owe on the mortgage, having to pay $25,000 more in taxes than I would get out of the sale.
If, on the other hand, I kick the bucket tomorrow and my children decide to sell, they’ll net $120,000. Be aware, this example is based on today’s tax law, which is currently in negotiation. If the Biden Administration has its way, things could shift dramatically, and your kids would inherit your tax liability.
I share these examples to spark your interest. I am by no means giving tax advice. Your investment decisions should be made in collaboration with your tax accountant or other qualified financial planner.
If you have questions about property management or real estate, please contact me at email@example.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery. Dick Selzer is a real estate broker who has been in the business for more than 45 years.