How Does Grandma Pass Along The Country House?

Objectives: Split the value of a homestead, avoid taxes and avoid family squabbles.

“My mother-in-law is 94. She owns a house in Vermont, appraised at $700,000. Her will leaves everything to be split equally between her two kids: my wife and my wife’s bother.

“The brother has offered to give my wife a check for $350,000 for her share in the house so he can move in now. My mother-in-law then would rewrite her will to leave the house to the brother with the rest of the estate split.

“What are the tax implications? Maybe the brother could carve up the payment to take advantage of the $16,000 annual gift tax exclusion?”

Dan, New Jersey

Something for siblings to fight over (Photo by John Greim)

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My answer:

You are juggling two ambitious goals: avoiding tax and avoiding family disharmony. These goals may conflict. Let’s see if we can reconcile them.

I confess that the abbreviated version of your query displayed above doesn’t do full justice to the situation. The details omitted make clear that you have in play not only a proposed real estate transaction but a lot of emotional baggage. Certain in-laws don’t get along with certain others. The unequal disposition years ago by the family patriarch of a valuable business asset left in its wake resentments that still simmer.

Even when everybody is getting along, it’s no easy matter to happily dispose of a family vacation home to which is attached both a large price tag and powerful childhood memories.

I can’t do much in the way of family counseling, but I can weigh in on structuring an asset transfer. I think your relatives’ idea about how to go about this is cockeyed.

To make this story easier to follow, I’ll make up some names. Let’s call your wife Jill, her brother Jack and their mother M. I gather that M is single and uses the house at least part of the year.

Just write out a check? That’s awfully trusting. What if M rewrites her will to leave the house to charity? Or, what if, when M dies, Jill refuses to sign over her half of the house?

Suppose, instead, that M deeds the property to Jack and Jill right now, perhaps retaining some limited right to use part of it for as long as she lives. Now Jack offers Jill $350,000 for her half. That eliminates the risk that someone will pull the rug out from under Jack. But it creates tax problems.

M would have to file a Form 709 disclosing two $350,000 gifts. This would eat into M’s lifetime gift/estate tax exclusion. To be sure, if her net worth is well below $5 million (Vermont’s starting point for estate tax), this will cost the family nothing, but there’s another problem: tax on the appreciation.

Let’s say the family acquired the country house many decades ago for $70,000 and has put $50,000 into improvements. That would make the cost basis $120,000, or $60,000 for each half. This basis carries over to Jack and Jill when they get the gift. When Jill sells to Jack, she’d have to report a $290,000 gain, and since the house is not her principal residence she’d be entitled to no home sale exclusion.

Here’s a better solution: Jack rents the house with an option to buy it. When M dies, he exercises the option.

As long as M is still the owner at her death, the cost basis gets stepped up and the family has no taxable gain to declare. Jill would get the value of her half when the estate is settled. But if Jack is confident that he will someday exercise the option, he could move in now and even be comfortable putting money into improvements.

It is important to structure the option and rental contracts so that the IRS cannot declare the transaction to be a disguised sale. I would recommend contract provisions like these:

—A payment by Jack to M for the option, perhaps $7,000. This would be taxable ordinary income to M only if and when the option expires unexercised, an unlikely outcome.

—A strike price close to the $700,000 appraised value.

—An escalator, such as 3% per year. So if M dies at 98, the price would be $784,000 and Jack would be handing Jill a check for $392,000 to settle this part of the estate.

—A low but defensible rent, such as $21,000 a year. M would have to declare this as rental income, but she’d be able to deduct property taxes, upkeep, insurance and depreciation on a 27.5-year schedule. (With a cost basis of $120,000, depreciation would be $4,363 annually.) She would likely have no net income to report. The step-up at death would eliminate the potentially taxable recapture of depreciation.

—An assignability of the option and the lease. So if Jack dies before exercising the option, his widow or kids could step into his shoes.

It would be a good idea for Jill to assent in writing to the lease and the option.

My advice to you, Dan, is to be careful not to inject yourself too deeply into the negotiations among your in-laws. But you might nudge Jill and Jack toward working out a deal on their own, then heading with their mother to the office of a Vermont lawyer.

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