Tom Kelly: Bargain basement mistake – selling too low to your child

If you sell a cabin to a friend of a friend for less than fair market value, the Internal Revenue Service really doesn’t care. That lucky person simply came away with a bargain retreat.

When you deal the wonderful getaway to a child or close relative at too low a price, however, the IRS red flags begin to surface. You could be scrutinized for making a gift – the difference between the sale price and fair market value.

For example, if your waterfront getaway is worth $400,000 and you sell it to your child for $250,000, you just made a gift of $150,000. Of course, you can use your annual gift exclusion to whittle this down by at least $15,000 (the amount you can gift tax free to any individual) and maybe up to $60,000 (both spouses each gift to both husband and wife.)

For income tax purposes, you subtract your tax basis in the home from the $250,000 sale price to calculate your gain or loss. Any loss is nondeductible. Your child’s tax basis on the home will be only $250,000, however, which increases the likelihood that he or she will owe income tax on a later sale, unless it is converted into investment property and traded via a 1031 Tax-Deferred Exchange.

Instead of making a bargain-basement sale, you could consider making an installment sale for full market value instead. This method could still meet your primary objective of transferring the home to your kids in a way they can afford – and with more favorable tax ramifications.

For example, let’s say you sell the lake cabin to your children for a relatively small down payment and carry a note for the balance of the purchase price. Let’s again say the property is worth $400,000 and your child can afford to pay $30,000 down. So you take back a note and deed of trust for $370,000. Make sure everything is in writing, including the note and that the kids can combine to make the monthly payments.

The amount of the payments also are important. You must charge at least the applicable federal rate, or AFR, on the loan. That rate, which is well below the average commercial mortgage rate, is available monthly in the Internal Revenue Bulletin. Also, as long as you go through the legal process of securing the note with the lake place, your children can deduct the interest payments to you as mortgage interest.

You can then help ease your child’s financial burden by making gifts under the annual $15,000 gift-tax exclusion rule. Just make sure your child actually makes all the payments on the note. Then write checks for any gifts you decide to make. That keeps the gifts, the note and the sale separate. If you simply forgive some of the payments, the IRS may classify the deal as a bargain sale and the tax bite could be far worse.

As far as federal income taxes are concerned, you will be viewed as making a sale for $400,000, minus your adjusted basis. You will owe income tax on your interest income from the note. But remember, your children will get a mortgage interest deduction.

The kids’ tax basis on the lake property is now the full $400,000 purchase price, which reduces the amount they will owe in federal income tax when the lake property is eventually sold again. In addition, the sale removes from your taxable estate any future appreciation in the value of the home.

A few years after the sale, your kids may be able to refinance and pay off the note. However, if there’s still a balance due when you die, your children will be treated as receiving “a bequest” if the note is forgiven. This uses up part of your estate-tax exemption, but few consumers have little to worry about because your estate tax exemption is $11.58 million in 2020, up from $11.4 million in 2019.