Gift Tax, Capital Gains Tax, Or Inheritence Tax??

Q: An elderly aunt wants to give us her home as she can not keep up with the taxes, insurance, etc. She will live there as long as she wants to. We will be paying taxes, insurance, etc. The house is worth $90,000 and was purchased 40 years ago for $10,000. The aunt and I both live in PA. A real estate lawyer has advised us to arrange to "buy" the home from her. We would have to pay 2% real estate transfer tax and any other settlement costs. After settlement, she will immediately forgive the debt. According to the lawyer, this scenario would eliminate any capital gains taxes which he claims we would have to pay if she just gives us the house outright. The lawyer thinks my aunt may have to pay a gift tax but he was not sure and advised us to check with a tax lawyer. Is the above scenario legal and the best was to avoid taxes? Would my aunt have to pay state or federal gift taxes? Could we deduct the 2% transfer tax, overdue real estate taxes, and future real estate taxes from our income tax? Why would capital gains tax have to be paid if she gives us the house outright? Thanks for any advice!

A: Taking the issues one at a time (but not in the order you present them): 1. The recipient of a lifetime gift takes the same tax basis as the donor, so a lifetime gift, followed by a sale of the property, could result in a capital gain of $80,000 and federal income tax of $8,000 to $16,000, depending on your income tax bracket. Property owned at death and subject to federal estate tax receives a new basis. 2. The real estate lawyer may be correct in saying that an outright gift would cost more in capital gains tax than it would save in death taxes. There wouldn't be any federal estate tax unless your aunt's estate is more than $625,000, so a lifetime gift seems to save nothing in federal estate tax and cost a significant amount in federal income tax. 3. The real problem is the Pennsylvania inheritance tax of 15% (the rate payable by nephews and nieces). There is no lifetime gift tax, but owning the property at death, and leaving it to nephews or nieces, would seem to cost $13,500 in Pennsylvania inheritance tax. 4. Giving the home to you and retaining the right to live there doesn't do any good because the property will still be subject to Pa. inheritance tax at her death. 5. The idea of "selling" the house, and then giving you back the proceeds doesn't impress me either, because it really looks like a lifetime gift dressed up to look like a sale, and she is still living in the house (which often makes tax officials suspicious that something funny is going on). A better idea might be to transfer the property into joint names with right of survivorship. There would still be a 2% transfer tax payable (which is not deductible) but, because of a quirk of Pennsylvania law, only a fraction of the property would be subject to inheritance tax. For example, let's assume that the "us" to which your aunt will transfer the property is you and your sister. Once all three names are on the deed, and more than one year has passed, only one third of the property is subject to Pennsylvania inheritance tax, while the entire property is still subject to federal estate tax and would get a new income tax basis at death. The total tax cost would be 2% on the $60,000 value on the two thirds transferred during lifetime ($1,200 I think; unless there is an actuarial calculation involved), and the 15% tax on the $30,000 value remaining at death ($4,500), or a total of $5,700, which may be as good as it gets. By the way, all of these problems are caused by the aunt's desire to live in the house during her lifetime. If she were willing to sell the house and give you the proceeds, there probably wouldn't be any tax at all (other than her share of the 2% transfer tax, and the costs of sale). So, you need to talk to a Pennsylvania lawyer who can figure out a solution for you.

Gift Tax, Capital Gains Tax, Or Inheritence Tax??

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