Tax

With today’s home prices and the crazy real estate market, it’s likely difficult for your children to buy a home. And it’s conceivable that you are ready to move on from your existing home.

If this is true, consider the three options below.

Option 1: Make an Outright Gift

Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid!

Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.

If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.

If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.

If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.

Option 2: Arrange a Bargain Sale

Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.

Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.

Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you depart this planet. In these scenarios, expect the IRS to argue that the home’s full date-of-death fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.

Option 3: Arrange Full-Price Sale with Seller Financing from You

The idea of giving your home-starved child a big free lunch might be unappealing. Very well.

Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price.

Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).

AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In April 2022, the long-term AFR, for loans of more than nine years, is only 2.25 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 1.87 percent (assuming annual compounding).

As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.1 percent, while the rate for a 15-year loan was around 5.6 percent.

So, for a loan made in April 2022, you could take back a 30-year note that charges the long-term AFR of only 2.25 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 1.87 percent. Either arrangement would be a money-saving deal for your child.

If you would like to discuss transferring your home to your adult child, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• June 9, 2022

The federal income tax tables do not give you your “true” tax rates.

Here’s one example: the net investment income tax (NIIT). It’s a hefty 3.8 percent on top of what you pay according to the table rates.

If you own rental property, you’re one of the NIIT’s prime targets.

You pay the NIIT only if

• your modified adjusted gross income (MAGI) exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly ($125,000 for married couples filing separately), and
• you have net investment income.

Your MAGI for NIIT purposes is likely the same as your adjusted gross income (AGI), which equals your gross income less any above-the-line deductions. The tax code modifies the NIIT AGI only for certain U.S. citizens or residents who live abroad.

You pay the 3.8 percent NIIT on the lesser of

• your net investment income, or
• the amount your MAGI exceeds the applicable $200,000/$250,000 threshold.

NIIT Exemption #1: Real Estate Professionals

Don’t let the term “real estate professional” scare you away. For the NIIT, the tax code defines the real estate professional. You may qualify.

When it comes to rental property, tax-law-defined real estate professionals earn supreme status because they

• deduct their losses from non-rental income, and
• most likely qualify to have their profits escape the NIIT.

Thus, if you can achieve tax-law-defined real estate professional status, you have the best of all tax worlds: deductible losses and (most likely) profits that escape the NIIT.

You may have noted “most likely” in the sentence above. You overcome the “most likely” on the NIIT when your rental activity qualifies as a business for tax purposes.

Real Estate Professional Status

To qualify as a real estate professional, either you or your spouse (if you file jointly) must spend (1) over 50 percent of your work time in a real estate business or businesses and (2) over 750 hours working in real estate businesses during the year.

Material Participation in Rental Activity

In addition to being a real estate professional, you must materially participate in your rental activity to deduct your losses or qualify for the NIIT exemption. There are seven ways to establish material participation. The two most common are

• doing all the work on the rental, or
• working more than 100 hours on the rental and that’s more than any other individual works on the rental.

Rental Activity as a Business

There is one more hoop you must jump through for the NIIT exemption: Your rental activity must qualify as a business, not a mere investment activity, under IRC Section 162. Most rental activities are businesses even though they’re reported on Schedule E, but the legal tax definition is somewhat nebulous.

NIIT Exemption #2: Short-Term Rentals

You have a short-term rental when the average tenant stay is seven days or less, or when it is not more than 30 days and you provide services. The short-term rental is exempt from the tax-law-defined real estate professional rules. To deduct your losses on a short-term rental, you need to materially participate in the property.

You are subject to the NIIT on your short-term rental if (1) you materially participate and (2) the rental is a tax-code-defined business.

NIIT Exemption #3: Self-Rentals

Passive income from rental property that would otherwise be subject to the NIIT is recharacterized as non-passive if you rent the property to a business in which you materially participate. In other words, income from self-rentals is not included in net investment income.

If you would like to discuss how your rentals interact with the NIIT, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• June 2, 2022

Do you give money to your church?

Do you get a tax benefit from those donations?

How about your donations to other charities?

Recent changes in the tax code have done much to destroy your benefits from church and other tax-deductible 501(c)(3) donations. But there’s a way to donate the way you want, get revenge on the tax code, and realize the tax benefits you deserve.

This get-even tool is the donor-advised fund, an increasingly popular way to donate to your church and other 501(c)(3) organizations. Indeed, donor-advised funds have exploded over the past few years, with over one million donor-advised fund accounts in existence as of 2020.

Example. You donate $100,000 to the fund today. You get the $100,000 deduction now. From the fund, you donate $10,000 a year to your church (probably more as your money in the fund grows tax-free).

National investment firms such as Fidelity, Schwab, and Vanguard have all created donor-advised funds. These “commercial” donor-advised funds hire an affiliated for-profit investment firm to manage the assets in the accounts for a fee that varies based on the account balance.

You can also establish a donor-advised fund account with a community foundation that has a local orientation; a single-issue non-profit, such as a university or an environmental charity like the Sierra Club; or an independent, non-commercial organization such as the American Endowment Foundation, National Philanthropic Trust, or United Charitable.

You can always donate cash, including money in IRAs and 401(k)s, to your donor-advised fund account. But many donor-advised funds also accept non-cash donations, including

stocks, bonds, and mutual fund shares,
real estate,
privately owned company stock,
LLC and limited partnership interests,
Bitcoin and other cryptocurrency, and
life insurance.

Donating stock or mutual fund shares that have appreciated is a great tax strategy. Here’s why:

If you owned the stock for more than one year, you get a deduction equal to its fair market value at the time of the donation.
And you don’t pay any capital gains tax on the appreciated value of the stock.

Example. Darius owns 1,000 shares of Evergreen stock that’s publicly traded on NASDAQ. He paid $10,000 for the stock back in 2010, and the shares are worth $100,000 today.

He establishes a donor-advised fund in 2022 and donates the stock.

He gets a $100,000 charitable deduction for 2022.
He pays no federal tax on his $90,000 gain.

As you can see, there are many benefits to donor-advised funds for the charitably inclined, and few drawbacks. If you would like to discuss donor-advised funds, please don’t hesitate to call me on my direct line at 408-778-9651.

• By Leon Clinton
• May 26, 2022