Selling House to Children With Intent to Forgive Debt Can Lead to Tax Problems

Q: We purchased our house in the early 1980s for $50,000. It is now worth more than $700,000.

We are considering selling it to our three children at market value and taking back a note -- secured by a deed of trust -- for the full sale price. In effect, our children would purchase the house for around $700,000, and agree to pay us a monthly mortgage payment.

We have told our children that at some point, we will forgive the note, and they will own the property free and clear. We have no mortgage on the property now.

There are several reasons we want to do this. First, even though we are eligible for the exclusion of capital gains tax on $500,000 of our profit, if we sell the property outright, we will still have to pay capital gains tax on the difference between the $500,000 and the $700,000 sales price. We understand that what we propose would be considered an installment sale and thus we will be able to spread out our tax payments over the years.

And, perhaps the most important reason: Our children's basis in the house would be the amount of the note.

Can we do this?

A: It is risky, and you must consult competent and knowledgeable tax advisers before you proceed.

Let's review some basics first:

Transactions between family members are subject to extra tax scrutiny, and there is a presumption in the law that a transfer between family members is a gift. When anyone gives real estate as a gift, the tax basis of the donor (the person giving the gift) becomes the basis of the recipient. Thus, I often strongly counsel parents not to give the family home to their children. Your basis in the property is probably somewhere in the neighborhood of $50,000, unless you made significant improvements. If you just give your house to your children, their basis will be the same, which means that they will have to pay a considerable amount of tax when the house is ultimately sold.

The Internal Revenue Service and the tax courts have long held, "if an individual makes a loan, and as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration, and the donor will have made a gift at the time of the loan to the full extent of the loan."

Currently, an individual can make an annual tax-free gift of up to $12,000 to anyone else. There is a complicated formula to determine the tax consequences for any gift over that amount that is tax free. Your tax adviser will have to assist you with that analysis.

Your objectives are understandable, but there are real risks involved. Recently , the IRS issued a private letter ruling (PLR-111383-05) that gives some guidance and some cause for concern. Although the facts involved in the ruling dealt with life insurance policies, the analysis is equally applicable to real estate.