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Myth Busting: Transferring the Family Home before Death

March 14, 2023

Many parents transfer their home to children to avoid estate tax – but that may set up their heirs for bigger tax burdens down the road.

Recently, I heard for the third or fourth time, a piece of advice many people in Pennsylvania may have heard before: “You should have your parents transfer their home to you now that they are getting older.”  When I have asked why they are doing this, the answers are variations on the same basic principle – to avoid tax!  While this advice is well-intentioned, the reality is transferring the family house is often not the best option.

When friendly advice turns out to be incorrect, there is usually some factual basis for its origin.  In this case, it is trying to avoid estate and inheritance taxes.  While the federal estate tax is not applicable to estates worth more than $12 million ($ 24 million for married couples), many states, including Pennsylvania, have their own estate or inheritance tax.  When a person who resides in Pennsylvania dies, the value of all their property as of the day that they died is added up and is subject to Pennsylvania Inheritance Tax.  If any piece of property is no longer owned by the decedent as of the day they die, that property is typically not included in the decedent’s estate and not subject to inheritance tax.  (One caveat here is that they must survive the gift of that asset by at least one year.)  Thus, the rumor is born.  “Why include your home in your will to your children if you can transfer it to them now and avoid inheritance tax?”  The reason, “stepped-up basis.”

What is Stepped-up Basis?

Whenever someone sells property, whether it is stock, an antique car, or a piece of real estate, they have to calculate whether they have a capital gain or a capital loss. If the price they paid when they bought the property, called their “basis,” is less than what they are now selling it for, that difference will be a capital gain and subject to capital gain taxes. If they sell it for less than what they paid for it, they may have a capital loss.  So how does this work when the seller received the property through a gift?

When property is gifted to an individual, that individual receives the property with the giver’s tax basis. This means that if you bought your house twenty years ago for $70,000, and you gift it to your children, they will get the property with your tax basis of $70,000.  If they later sell the property for market value and the sales price is $170, 000, they will realize a capital gain of $100,000.  Currently, the capital gains tax rate is 0%, 15% or 20%, depending on the taxpayer’s tax bracket for that year.  Generally speaking, most people will pay at the 15% capital gains tax rate. The 20% tax rate applies to persons with incomes over $450,000.  So, using the example cited above, in the case of a person earning $100,000 a year, if they are gifted a house by their parents, and the parents’ tax basis was $70,000, and they sell the property for $170,000, they will realize a capital gain of $100,000 and will have to pay $15,000 in capital gains taxes on the sale of that property.

On the other hand, if the house is inherited, the recipient gets “stepped-up basis” meaning their basis is whatever the fair market value of the house was at the time they inherited it.  So again, using the example from above, the parents paid $70,000 for their home.  In their wills, they leave their entire estate, including the home, to their son.  When the second parent passes away, the son receives the house, but in this case, the tax basis is stepped-up to the date of death fair market value of $170,000.  The estate will pay Pennsylvania Inheritance Tax on the full $170,000 value at a rate of 4.5%.  The tax (not taking into consideration any available deductions) would be $7,650.

For property that has been owned for more than a decade, the benefits of stepped-up basis are nothing less than immense.  If a child sells a home soon after inheriting it, they will pay no capital gains taxes because their basis will be the same as the fair market value.  However, if a child were to receive the home from a parent during the parent’s life, the child would take their parent’s basis in the property.  Any subsequent sale of the property would incur significant capital gains tax liability.  So, while gifting a home to a child instead of leaving it them in your will can alleviate having to pay 4.5% inheritance tax on the home, the savings will likely be washed away by the significantly higher capital gains rates when the home is sold (15% for people making more than $42,000).

Whether this notion that you should gift your home to you children before you die is a helpful piece of advice or a misleading rumor depends on your situation.  Stepped-up basis can eliminate significant capital gains taxes, but there are reasons that can make lifetime gifting worthwhile such as qualifying for Medicaid long-term care, protecting assets from creditors, and when property is a family heirloom unlikely to ever be sold.  If the reason for gifting the house is to become eligible for Medicaid long-term care, additional rules apply, including the Medicaid Look-Back Rule, which will allow a lien to attach to the gifted property.  The rules for Medicaid eligibility are complex and require sophisticated planning with the aid of an eldercare law attorney.  For more information or help with estate and tax planning contact us online or call (412) 338-1100.