Should I Deed My Pennsylvania Property to My Child While I Am Still Living?
Inheritance tax must be paid on real property located in Pennsylvania when an owner dies, regardless of whether or not the owner was a Pennsylvania resident at the time of his or her death. Accordingly, a property owner might wonder if it makes sense to grant part or all of the real property to a child or another relative during their lifetime in an effort to reduce inheritance tax liability. So long as the transfer occurs more than a year prior to the owner’s death, the transferred interest will not be subject to Pennsylvania inheritance tax. While this type of transfer may decrease or eliminate Pennsylvania inheritance tax liability, it could increase capital gains tax liability. Thus, understanding capital gains taxation is crucial in understanding whether this type of inter vivos, i.e., during one’s lifetime, transaction is right for you.
Capital gains tax is levied by the federal government on the sale of capital assets, including real estate. When you sell a capital asset, the difference between the “adjusted basis” in the asset and the amount you “realized” from the sale is a “capital gain” or a “capital loss.” If you hold an asset one year or less before selling it, your capital gain or loss is short term. If you hold a capital asset more than a year before selling it, your capital gain or loss is long-term. Short-term capital gains are subject to taxation as ordinary income at graduated tax rates. Long-term capital gains are typically taxed at a rate of 15% or 20% depending on your taxable income and filing status. Pennsylvania also levies capital gains tax at a flat rate of 3.07%.
When an owner of an asset such as real property dies, and the asset has appreciated in value since its purchase, the person who inherits that asset gets a “stepped-up” basis in that asset equal to the date of death value of the asset. This typically means that when the asset is sold after death as part of an estate proceeding, the new owner has a capital gain of $0 and pays no capital gains tax. Therefore, inheriting a capital asset with a stepped-up basis can provide a significant tax savings.
Another important thing to consider is that the sale of a primary residence may be subject to an exclusion from federal capital gains tax. Generally, you are eligible for the federal exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. If you meet this criterion, you may qualify to exclude up to $250,000 of that gain, or up to $500,000 of that gain if you file a joint return with your spouse. Also in Pennsylvania, the sale of a principal residence where the owner meets the ownership and use criteria is wholly exempt from capital gains tax.
Let’s work through some examples to understand inheritance tax and capital gains tax liability. Grandma purchased some real property for $50,000. Grandma died owning 100% of her real property, and you inherited 100% of that real property. A few months after Grandma died as part of Grandma’s estate proceeding, you sold the real property for $100,000. Assuming no improvements were made to the real property between the time it was purchased and the time it was sold (for simplicity’s sake), your adjusted basis in the real property would be “stepped up” to $100,000. You would have long-term capital gain of $0 and pay no capital gains tax. You would, however, pay 4.5% in inheritance taxes on $100,000 as a lineal heir.
Let’s work through a second example. Grandma purchased some real property for $50,000. While she was still living, Grandma granted you an interest in the real property: you became a 50% joint tenant with right of survivorship. You never lived in the real property. Grandma died more than a year after the transfer, and upon Grandma’s death, you inherited her 50% interest in the real property. A few months after Grandma died, you sold the real property for $100,000. Assuming no improvements were made to the real property between the time it was purchased and the time it was sold, your adjusted basis on your 50% inherited interest in the real property would be stepped-up to the date of death value—50% of $100,000—and you would pay no capital gains tax on that inherited 50% interest. But you would pay capital gains tax on the long-term capital gain realized from your 50% interest:
Long-term capital gain from your 50% interest = 50% x ($100,000 – $50,000) = $25,000
You would also pay 4.5% in inheritance taxes on the 50% inherited interest as a lineal heir. Also, keep in mind that if you had predeceased Grandma, Grandma would have inherited your 50% interest, and she would have had to pay 4.5% in inheritance taxes on the inherited 50% interest. Right of survivorship ownership avoids probate, as the remaining living owner owns the entire property upon the death of the other owner.
Let’s work through a third example. Grandma purchased some real property for $50,000. While she was still living, Grandma granted you 100% of the real property. You lived in the real property with Grandma for two years. Grandma died more than a year after the transfer, and you sold the real property for $200,000. Assuming no improvements were made to the real property between the time it was purchased and the time it was sold, your adjusted basis in the real property would be $50,000. You would have a long-term capital gain of $150,000 ($200,000 – $50,000 = $150,000). Here, you did not get a step up in basis. But, so long as you had owned and used the real property as your main home for a period aggregating at least two years out of the five years prior to its date of sale, you would qualify for a federal capital gains exclusion of $250,000 and would pay no federal capital gains tax. You would also pay no Pennsylvania capital gains tax. Lastly, you would also pay no inheritance taxes on the real property because the transfer occurred more than a year before Grandma died.
As you can see from the examples, whether or not you should transfer your real property to your child or other relative during your lifetime depends on your specific situation. Capital gains taxation rates are typically higher than Pennsylvania inheritance tax rates, so it’s important to consider whether an inter vivos transfer of real property might trigger capital gains tax liability for a beneficiary in the future. It is important to consider whether or not the person you transfer the real property to will live in the real property and be able to meet the homeowner exclusion for capital gains tax. If a real property that you own has appreciated in value significantly, and the ultimate goal is to sell the property after your death, then the most beneficial tax situation to your beneficiaries may result from your continued ownership of the real property, due to the step up in basis that they receive upon your death.
