In the past few years there’s been lots of talk online about how to create multi-generational wealth. We see this a lot with ultra-wealthy families — think Rockefeller, Carnegie, and Rothschild — but wealth creation strategies and financial engineering are becoming much more commonplace among your average Americans. One of the more common financial strategies is buying a house from your parents below market value.
There are a lot of factors that come into play that may affect how you buy your parents home and how you execute on the purchase. Here we’ll explain those factors as well as the different types of taxes associated with this kind of purchase. For example, you cannot do this for fraudulent reasons e.g., trying to scam your siblings out of their share and there are always specific tax implications in this type of transaction.
Find the best way to unlock your home equity
How do you go about it?
So how do you go about the process? Well, there are two main steps:
- Finding out the market value. The first thing you need to do is assess similar properties in the area and look for any recently sold houses. Compare that to your parent’s house and get an estimate of the home’s value. Most real estate agents will give you a free home appraisal too and if you want an official, impartial judgment, you can hire a bank-approved valuer, although they’ll be charging some fee.
- Deciding on an amount between you and your parents. Once you know the market value of the house, you can reach an agreement with your parents about the amount you’ll be paying for it. The price should not be too low as it can raise questions and bring scrutiny to you because it might appear like the sale is being made as part of some fraud/ scam or that you’re trying to take advantage of your parent’s old age by depriving them of assets.
What basically transpires here is that your parents ‘gift’ you equity in the property. Let’s suppose that the actual price is $800,000 but you buy it for $650,000. Thus, $150,000 has been gifted to you and whatever remains is the amount you have to pay.
Factors that can affect your home purchase from your parents
No two purchases are the same. Different circumstances, stakeholders, laws, etc. can influence different sales in various ways. We’ll be discussing some major factors that play a huge role in determining the exact outcome of your purchase and might even be a deciding component in whether or not you buy the house from your parents at all.
Difference between the market value and the sale price
As mentioned above, your parents are essentially gifting you equity in the house and this equity is equal to the difference between the market value and the price for which you’re buying the house.
Currently in the US (at the time of writing the year is 2022), the maximum limit for a gift is $16,000 per individual or $32,000 for a couple. If the difference between the market value and the sale price exceeds this amount, the seller, or in this case the parents, will have to file a gift tax form. You can also use the $12.06 million tax exemption i.e., the amount that you can gift in your lifetime without incurring any taxes (as of 2022, the amount may vary depending on the year).
How long do your parents live after the sale?
As discussed above, in normal circumstances, a purchase like this between family members is liable to gift tax and the exemptions possible also apply to it. However, there’s a three-year rule in the USA that applies to properties sold for less than the fair market price which can entirely change the tax implications. For that reason, it is important to be aware of it.
Estate taxes are federal taxes that are payable on the estate of a person or on the transfer of property to their beneficiaries, when said person i.e., the owner dies. Suppose your parents sell you their home at a price lower than the market value, essentially gifting you a substantial amount, and then pass away less than three years after the sale. In this case, instead of the normal gift tax, the state will consider the ‘gifted’ part as a part of the gross estate of the descendent, which essentially means that estate tax will be imposed on this part, and while calculating tax, it will be added to their total assets, subtracting the annual allowance of the gift amount.
So, for example, the difference between the market and sale price was $70,000 and your parents die before three years. This $70,000 is now a part of their total estate. However, since the law allows for a maximum amount of $16,000 as a gift per year, the first $16,000 from the $70,000 will be free from tax. The estate tax will be calculated on the remaining $54,000. However, if your parents had lived past the three-year mark, the entire amount would be free from estate tax.
Is this your parent’s main residence?
If the house is not your parents’ primary residence, it will incur significant capital gain tax (CGT) when they sell it to you. This is because a secondary residence is considered an investment property (a property solely for profit or rental reasons) and according to the rules of the Internal Revenue Service (IRS) is not eligible for the tax exemption extended to principal properties.
For your parents to be entitled to CGT exemption, they must follow the 2-in-5-year rule which basically states that if the owners have lived in the house for at least two out of the last five years or for 730 days, this house can be considered the primary residence and hence CGT won’t have to be paid on it, as long as the profit does not cross the IRS threshold.
Do your parents continue to live with you?
There are two possible cases if your parents continue to live with you after the sale:
- Sold at fair market price and pay normal rent: This is a normal situation in which your parents are like any other normal renters, therefore it is a perfectly acceptable deal.
- Sold for below the market value and pay less rent: In this situation, the full fair market value of your home will be included in the estate when tax is calculated at the time of your parent’s death and you can’t avail rental deductions either.
Can the sale be considered a deliberate deprivation of assets?
After the sale, if your parents go to a care home and apply for funding, the local authority will conduct a means check to see if your parents can pay their own fees or not. If at that time, they discover that your parents sold you the home for below market value, it will be considered a deliberate deprivation of assets to avoid paying fees themselves. The local authority may then transfer the home back in your parent’s name, consider it their possession, and make them liable for paying for their care.
Suppose that your parents become bankrupt in the future. In this case, a person is appointed to deal with their debts who is called the Official Receiver, who may overturn any previous under-market transactions and use them to pay off your parent’s creditors.
Divorce or other family disputes
These are common issues that can manifest themselves in the following two ways:
- Falling out: If your parents continue to live with you after the sale and then sometime later you have a major falling out with them, it puts them in a vulnerable position. Since you are the legal owner of the house, you have the right to evict them at any time.
- Separation: If you’re married, the property will be considered a matrimonial asset and thus will be a part of the divorce settlement. It will be divided between you and your ex-spouse which again puts your parents at risk in the case that they are living with you.
You die before your parents die
Although highly unlikely, it is completely possible that you pre-decease your parents. The property will then be considered a part of your estate and this could cause problems for your parents (if they’re still living there) as your estate will go to your beneficiaries, leaving your parents with nothing, unless you specify otherwise in your will beforehand.
Consider a reverse mortgage
Reverse mortgages are an excellent way of keeping most of the equity, the money, and the interest within the family. But what exactly is a reverse mortgage?
In a typical reverse mortgage, homeowners aged 62 or older, who have completely paid off the mortgage on their home or own considerable equity in the home (at the very least 50%), borrow money from the lender against this equity. Thus, unlike a normal mortgage, in which the homeowner pays money to the lender, in this situation, the lender pays money to the homeowner. This money can be in the form of a lump sum, monthly payments, yearly payments, or a certain amount could be fixed which would be payable after a specific period. The debt of the borrower (i.e., the homeowner) to the lender has to be paid immediately in the event of his or her death or when they sell the home or move out immediately. Failure to do so gives the lender the right to foreclose the home and sell it to get their share back (i.e., the money they lent). Thus, this type of mortgage is not without its risks.
The maximum amount that the homeowner can borrow is called the principal amount and it depends on several factors like
- The age of the youngest homeowner/borrower or an eligible non-borrowing spouse
- The home’s value or the amount of equity current owners have
- Interest rates
- Home Equity Conversion Mortgage (HECM) limit
Reverse mortgages are an excellent option for older homeowners who do not have any other source of income and whose biggest asset is their home. The payments or proceeds made through a reverse mortgage are not taxable either (no income tax on them) as the IRS consider them as an advance on loan payment rather than an income.
Pros and cons of reverse mortgage
Like everything, a reverse mortgage is not completely good or completely bad either, it has some advantages but also carries some risks.
- Your parents can better manage expenses in retirement, it gives them additional cash for any needs like home repairs, medical costs, etc.
- Your parents don’t have to move from their home and can continue living there normally
- The income from such a loan is not subjectable to tax
- There are usually extensive requirements for this type of mortgage like a mandatory counseling session
- Originating costs, administrative costs, legal fees, etc, can be quite high
- While paying off the normal mortgage on the house, one can get a mortgage interest deduction, however, the interest on a reverse mortgage can not be deducted.
Tax implications associated with buying a property below the market value
When a transaction of this level takes place between two family members, the tax implications can be much more complicated than when simply buying a property from someone from the outside, especially if the property is being sold for less than its market value. Three major kinds of taxes that you may have to deal with are explained below.
Capital gains tax
Capital Gains Tax (CGT) is the tax paid on the profit of an investment or a non-inventory asset. It is usually not applicable if the house you buy is your parent’s primary residence, however, if it’s a secondary asset, CGT is liable.
The important thing to consider here is that CGT is always calculated using the market value, and not the price which you actually paid to your parents. So for example, your parents bought a house for $200,000 and then sold it to you for $250,000 whereas the market value at the time was $300,000. CGT will be calculated on $100,000 rather than $50,000. The CGT rate also varies depending on the year, current trends, and the tax bracket in which you fall.
Another important thing to notice here is that even of the property is your parent’s primary residency, and the profit amount exceeds the limit set by the IRS ($250,000 in 2022), then any amount over this limit will be liable to CGT. So, for example the profit was $350,000. No tax is applicable on the initial $250,000 but on the remaining amount i.e., $100,000 CGT will still be applied.
Property transfer tax
Regardless of from whom or for how much you buy the property, you will have to taxes for the legal recognition of your house’s documents.
Referred to as property transfer taxes, almost each state in the US will tax you on the value of property you transfer to someone. For example, the state of California charges $1.10 per $1000 of sale. On the other hand, Texas is one of the 13 states that does not charge a transfer tax at all!
You should keep in mind that despite what the state laws outline, each city and county can charge additional taxes on top of the standard set by the state. You’ll have to search up the specifications for the particular area in which you parent’s house is located.
By buying a house much lower than the market value, you might actually be able to save on a lot of stamp tax since it is calculated using the amount actually payed and not the market value.
As discussed earlier, if your parents die less than 3 years after selling you the home for less than the fair market value, the gifted amount or equity will be considered a part of their estate and might be liable to estate tax, if the gross value of the estate crosses $12.06 million. This is highly unlikely to happen. However, about a dozen states have their own estate tax laws as well as inheritance taxes which can be quite complicated depending on your specific circumstances. It is better to check these out before making a decision.
Get legal advice
Overall, buying a house for less than the market value sounds like a great idea but it carries certain risks. Every family’s situation is different and for your specific situation, the tax liabilities, selling requirements, etc. may be different. For this reason, it is important to consult an attorney and both sides should get their own independent legal representation so that they are fully aware of their case, and any pitfalls, downsides, or laws that may affect the purchase. A contract to which both parties agree and which takes into consideration their specification should also be drawn up and extensively explained to everyone involved before finalizing anything or making the sale official.