Our office is frequently questioned by parents regarding the advisability of transferring their home to their child or children. Typically, the motivation behind their desire is the avoidance of Pennsylvania Inheritance Taxes. Almost to a person, one of them will explain how they've been told by a relative or friend that this is the perfect way to avoid "... the kids having to pay inheritance taxes." Unfortunately, this "perfect solution" may not be so perfect because of the potential negative income tax consequences.
The tax laws provide that the "basis" of inherited property is that property's fair market value at the date of death (ie., the same value on which inheritance tax is based). However, the "basis" for property which is acquired by gift is the same as the basis of the donor. A simple example may help clarify this problem: Assume that Mrs. Smith, a widow, owns the home that she and her husband had purchased years ago for the sum of $25,000.00 and upon which they spent another $5,000.00 over the years in fix-up expenses. Therefore, her basis in the home is $30,000.00. Through the years, the house has appreciated to its present fair market value of $90,000.00.
If Mrs. Smith transfers the house to her children during her lifetime and survives for at least a year afterward, at her death the children will not have to pay the 6% Pennsylvania Inheritance Tax, thus saving $5,400.00 in inheritance taxes. However, because the children take the same tax basis as their mother had, when they sell the home for $90,000.00, they have a taxable gain of $60,000.00 (i.e., $90,000.00 fair market value minus their $30,000.00 basis). The taxes (28% Federal and 2% PA, approximately) on this gain are about $18,000.00.
If Mrs. Smith had kept the house in her name and the children inherited it at her death, an inheritance tax of $5,400.00 would have been due, but the children would have received a stepped-up basis equal to the value of the asset in the mother's estate (i.e., the $90,000.00 fair market value). Thereafter, if the children sold the property for $90,000.00, there would be no gain and the children would realize a net tax savings of $12,600.00.
Of course, there may be situations where a transfer during the parent's life is the better choice. If the home's present fair market value is close to the parent's basis, or if factors other than tax savings are important, the analysis may result in a different answer. In addition, it may be possible, under the proper circumstances, to structure the transfer of the property in such a way as to reduce the later income tax, gift tax, and/or Inheritance tax consequences. We urge you to consult one of us in the office for an analysis of your particular situation. A little prior planning by you can result in substantial rewards to those you love.
©2000 Gamble Mojock Piccione & Palmer, LLP