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Leaving your house to heirs
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September 21, 1998: 1:57 p.m. ET
Kids used to be able to just move in after their parents died. Not anymore.
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NEW YORK (CNNfn) - If you don't plan ahead for what happens to the family home, it's still likely that your kids will move in or sell it -- but there's the possibility they'll get socked with a ton of estate taxes in the process.
To avoid this, consider some of the following options:
I'm not going anywhere
If you want to stay in your home until you die, and your estate is worth less than the estate tax exemption of $625,000 per person, this is your best strategy.
When you die, your home's tax basis will move up to fair market value. So by staying, you and your heirs will avoid capital gains tax on your home's appreciation. And since the value of your estate is below the estate tax exemption, your heirs will owe no estate tax. They can move into the house, or sell it and keep the cash tax-free.
Give it away, give it away now
If you plan to move out of your home, you can give the property to your kids today. But you'll likely have to use part of the $625,000 estate-tax exemption.
Here's what you can do:
First, offset the amount of the gift by using your $10,000 annual gift-tax exclusion. So, if you and your spouse each give $10,000 to your child and his spouse, then you've accounted for $40,000 of the home's value. Then, if the remaining value of the house is less then $625,000, you won't owe any current tax, unless you made other big gifts earlier that ate into your remaining exemption.
What's the catch? There are two of them, actually. First, your child's tax basis on the home will be your low cost for the property, which means he will likely owe taxes on a later sale. Secondly, you've dipped into your estate-tax exemption.
On the up side, however, any future appreciation in the home's value will fall outside of your taxable estate, which could be a big plus.
"Since so many regions are experiencing such quick price appreciation, this could be a big advantage of this strategy," said Paul Ryther, estate lawyer in East Bloomfield, N.Y.
Selling for peanuts
If you thought you'd just give your kids a good deal on the sale price of your house, think again.
Suppose you sell the home for less than fair market value to a stranger. The IRS won't even blink, it will just assume you made a bad deal. But if you sell the same home to a relative for less than FMV, it's treated as if you gave a gift equal to the difference between FMV and the sale price.
"This isn't the freebie you might have been hoping for," said Gerald Condon, author of "Beyond the Grave; the Right Way and the Wrong Way of Leaving Money to Your Children and Others." "The IRS isn't letting this one slip through the cracks."
Selling for more, with financing
Instead of trying the above strategy, perhaps you could make an installment sale for full market value instead.
In other words, you sell the house to your kid for a small down payment, and carry a note with a current market interest rate for the balance of the purchase price.
For the payments, you have to charge the applicable federal rate (AFR) on the loan, which is below the average commercial mortgage rate, and can be found in the monthly IRS Bulletin. If you go through the proper legal process of securing the note with the house, your child can deduct the interest payments to you as mortgage interest.
After setting this up, you can make gifts under the annual gift-tax exclusion rules to further ease your child's burden, making sure that he continues to make payments on the note.
One problem with this setup is you will owe tax on your interest income from the note. But keep in mind that your child will get an equal mortgage interest deduction, so you will still be helping him out.
But I don't want to move!
If you transfer your home to a child but continue to live there, the IRS will raise some eyebrows -- but it is still possible.
The key is, you must make a full-market-value sale to your child, then be sure to pay him market-level rent if you continue to stay there.
If you don't, or if you sell for less or pay below-market rent, there's a tax code provision that could include the full value of your home in your taxable estate. The reason for this is you're considered to still own the home since you never gave up "possession and enjoyment" of the property.
In addition, paying below-market rent will not let your child claim any deductible rental losses.
Qualified Personal Residence Trusts
There is one way to make a gift of your home while still living there, but it can be tricky.
To create a Qualified Personal Residence Trust, you transfer your home to an irrevocable trust. The trust provides that you are entitled to continue to live in the home rent-free during the existence of the trust.
After a specified period of time (for example, 10 years), the trust ends and ownership of the residence is transferred to your children.
The kicker is, to obtain a tax benefit, you must survive at least as long as the trust. If you do, the house will not be part of your estate for estate tax purposes. More importantly, for gift tax purposes, you've made a gift of only a portion of the value of the home. And if the home increases in value, all of the increase escapes estate and gift tax.
"If you choose a longer term, the potential tax savings will be greater," said Andrew De Maio of law firm De Maio & De Maio in Matawan, N.J. "Ideally, you want to choose a term that you are confident you will survive, but that will produce substantial tax savings." 
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