Q: My son is getting a divorce. The children are adults and not a concern to this but I am worried he is making a tax mistake. My son has proposed that he keep the house and buy out his wife’s one-half interest. He will do this by refinancing the home and will pay her half the equity based on the appraisal they obtain for the refinance. He will then own the entire home. My concern is that he is taking over his wife’s half of the potential tax when the home is later sold. It seems that the amount that he should be paying her needs to be tax-adjusted. Do you agree? How should this be done?
A: Technically it can be said that your son will now be responsible for all of the tax on any gain that is recognized when the home is sold. However, it may be that no gain is recognized for tax purposes.
The tax law allows someone who sells their principal residence to exclude as much as $250,000 of gain from taxable income. This doubles to $500,000 if the sellers file a joint tax return.
To qualify for this exclusion the house must have been the seller’s principal residence for two of the five years before sale. There are special rules when property is acquired in a divorce but I do not think they would apply here.
I suspect that your son will be in the same position as any other unmarried seller if he later sells this house. His realized gain will be the difference between the sales price and his tax basis in the home.
The tax basis in the home will be the purchase price paid by him and his wife, adjusted by any improvements they, or he, has made, and further adjusted by costs incurred to sell the home.
I’ve made a few assumptions, like he never rents the home or uses some of it for business use, and also that he and his wife didn’t defer gain from a prior house under pre-May 1997 tax law. If any of those issues exist the gain computation will change a bit.
But the key issue is – will his gain on sale exceed $250,000? If no, then he has no tax issues to worry about. He should keep records to support the claimed tax basis. If there is something unusual in his facts then feel free to ask me to clarify the response.
Q: My adult child has moved back home to live with me during the coronavirus shutdown. She will receive unemployment for several more months. I have not asked her to pay rent because I want her to save money for when the unemployment runs out. Will I have to report a gift for allowing her to stay with me rent free?
A: I do not think you have made a gift. The IRS at one time did try to argue that allowing someone to live in a house rent free was a gift. IRS made a similar claim when someone guaranteed a loan for another. The courts never accepted these arguments.
The gift tax applies when someone transfers property for less than full value. The estate tax applies when property is transferred at death. Both taxes are called “transfer” taxes and they operate in tandem.
The idea behind the transfer tax is to tax someone when they have taken an action that reduces the size of their estate. Size in this respect is something measurable in dollars.
So the tax law defines a gift as a transfer for less than full consideration in money’s worth. Silly example, but giving someone a compliment is not a gift because it cannot be expressed in money’s value. That “gift” does not reduce your monetary estate.
Allowing someone to stay at your home rent free may be said to have a monetary value, which would be the fair rent value. However, it does not reduce the value of your home so it does not reduce the size of your estate.
The Tax Court has generally required that a particular gift transfer reduce the dollar size of your estate to be a taxable gift.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.