How Do We Calculate Capital Gains on Gifted Property?

An irrevocable trust is a legal arrangement that generally cannot be easily changed or dissolved once it’s created. If your aunt’s home is held within such a trust, dissolving it to directly transfer the property to you and your wife as a gift can have tax implications.

As you may know, capital gains tax applies when you sell an asset (like a house) for more than what you originally paid for it. The difference between the sale price and the original purchase price (or “basis”) is the capital gain. (Note that the Internal Revenue Service (IRS) allows you to exclude a certain amount of capital gains if you are selling your own primary residence (Section 121 exclusion).)

Calculating Capital Gains on Gifted Property

Here’s a breakdown of how to calculate the capital gains in your scenario. Because this situation involves a gift rather than a sale, you need to use special rules to calculate the capital gain:

1. Determine Your Aunt’s Basis. Your aunt’s basis in the property is what she originally paid for it, plus the cost of any capital improvements she made over the years. This is key to calculating capital gains when the gift of property is made.
    
2. Determine the Fair Market Value. You will need to determine the Fair Market Value (FMV) of the home on the day your aunt gifts it to you. You may need to have the property appraised.
    
3. Capital Gains if Sold. If you and your wife eventually sell the house, you will need to determine the difference between your aunt’s basis and the amount you sell the house for. If you sell the house for more than the FMV at the time you received the gift, you will be subject to capital gains on the appreciation after you receive the gift.
    

Important Considerations

• Gift Taxes. While you might not have to pay capital gains tax on the gift itself, your aunt may have gift tax obligations. In 2023, the gift tax exclusion amount is quite high, but she would still need to report the gift.
   
• Step-Up Basis. When you inherit property, you typically get a “step-up” in basis to the property’s FMV at the time of the decedent’s death. This is important in the context of tax planning for people with significant wealth. However, since this is a gift not an inheritance this does not apply.
   
• Primary Residence Exclusion. When you sell your primary residence, you may be able to exclude a certain amount of capital gains from taxation. To use the primary residence exclusion, you must have lived in the house for two of the past five years.
   
• Tax Professionals. Tax law is complex and can vary based on individual circumstances. It is very important to consult with an experienced tax advisor or estate planning attorney for personalized advice. They will be able to consider all relevant factors and provide specific guidance based on the specifics of your situation.
   
• State Taxes. State capital gains taxes vary. You’ll want to find out the capital gains taxes for the state the home is located in.

Capital gains on gifted property involves understanding your aunt’s basis, the property’s fair market value at the time of the gift, and how these factors play into any future sale.

Disclaimer: This is not financial or legal advice. The information provided here is for educational purposes and general information only. It is not a substitute for professional advice. Consult with a qualified tax professional, financial advisor, or attorney before making any decisions about your specific situation.