When two people fall in love and decide to move in together, interesting tax questions arise about home ownership. Married couples don’t have this problem. If one spouse owns the home and wants to put the other spouse on title, there are no income tax consequences that result from the transfer of ownership. See IRC §1041, which was enacted in 1984. Nor are there any gift tax consequences. The 100% marital deduction was enacted in 1981. Before these dates, of course, even spouses had to consider gift and income tax issues relating to transfer of home ownership.
So today, when you try to figure out the tax consequences of transfers between partners in a state recognized same-sex couple relationship (marriage, domestic partnership, or civil union), you start by exercising your tax historian skills. That is, you research the tax law regarding spousal transfers before 1981.
And these old cases can be interesting (if you like history). In Lilly v. Smith, for example, the husband bought the residence and directed that he and his wife take title as Tenants by the Entirety. The IRS called that a taxable gift. The husband argued he was just providing support for his wife, something he was obligated to do under state law. The IRS won. Such transfers are subject to the gift tax. See Lilly v. Smith, 96 F.2d 341 (7th Cir. 1938).
And that rule has not changed. If Al transfers an interest in his home to Burt for no consideration, then Al has made a taxable gift to Burt. Most tax return preparers know this rule. But lately I’ve had a number of questions about what the correct overall tax result is when the gift transfer is of mortgaged property. And today, the day before my final exam in Federal Tax, I had at least ten tax students who got stuck on this issue. So I’ve had to give it a lot of thought over the past few hours and here’s what I want to make clear to everyone who confronts this problem.
When Al transfers mortgaged property to Burt for no consideration, the transaction is actually a part gift/part sale. That is because Burt will be treated as providing consideration for the transfer to the extent of his share of the mortgage. And it doesn’t matter whether Burt actually “goes on the mortgage” by signing a note to the lender or merely takes his interest “subject to” the outstanding liability. Ever since the Crane case, decided by the Supreme Court in 1947, nonrecourse mortgages have essentially been treated the same as recourse debt. The mortgage amount is included in the purchaser’s basis and it is treated as “amount realized” to the seller.
Here’s an example: Assume Al bought the residence years ago for $500,000. It is now worth $800,000. The balance on the original purchase money mortgage is $400,000. Al now transfers a 50% undivided interest in the property to Burt. Al appears to be making a gift of $200,000 (half the equity). But he is actually transferring a full 50% of the ownership, so that means Burt is taking a half interest in a home worth $800,000. Burt has ownership of a $400,000 asset. The transaction under which he acquired it is part gift (the $200,000 of equity) and part sale (he is agreeing, whether explicitly or implicitly, to pay $200,000 to the mortgagee to purchase the property).
The tax consequences are that Al has made a taxable gift of $200,000 (reduced by the $13,000 annual exclusion if this is the only gift to Burt this year) and he has also make a sale of the property to Burt for $200,000. Al has no gain on the transfer because tax law allows him to offset his full basis ($250,000 in the half interest transferred) against the $200,000 amount realized. The result is no gain.
What is Burt’s basis in his newly acquired property? The rule in the regulations is that in a part gift/part sale transaction the transferee takes the larger of donor’s basis (here, $250,000) or cost basis (here, $200,000). So the end result is no gain to Al, a taxable gift of up to $200,000 by Al, and Burt’s basis is $250,000 in his half of the home.
This would be the result for Al and Burt whether they are married, registered partners, or merely unmarried cohabitants. The main point here is that there is a taxable gift. However, many individuals don’t realize they are making a taxable gift when they transfer ownership in the home to the new partner.
Some people think that if they simply put the new partner on a joint tenancy deed, there is no real completed transfer until death. That is not true. The transfer is complete the moment the deed is delivered or recorded. A gift tax return should be filed. No tax may be due because every person still has a $1.0 million lifetime exemption. But a gift tax return is due whenever a “taxable gift” occurs, even if no gift tax is immediately due and payable.
