When parents find it too expensive or otherwise impractical to sell to their children, they often ask about the possibility of giving property to their children. Sometimes families use gifts with a sale, or in place of a sale, to help meet a family's goals.
There are many types of gifts. Most of us think of outright gifts of cash, chattels or real estate. However, the sale of the farm to the children at below fair market value or financing it under favorable terms is also a gift under federal law. There is nothing right or wrong with making gifts. However, there are some important rules, regulations and guidelines that one should consider.
There are two primary reasons for considering gifts. First, from the tax standpoint the primary motivation is the expectation that assets may appreciate significantly in value before death - causing them to be taxed at a higher rate. Secondly, from the personal standpoint it may seem important to get certain property transferred now so that the new owners can benefit from it.
On the other hand, it isn't always necessary, desirable or fair to make gifts to children. In some cases parents have already provided their on-farm children with significantly more advantages than their off-farm counterparts. Secondly, a significant gift will almost always reduce the financial security of the parents. Third, it isn't always in the children's own best interest to give them property.
Fourth, the children could sell the gifted assets or do other things with the assets that parents would not approve of. That could be good or bad. It may be good, if the parents have only made limited gifts, and the parents can adjust future transfers accordingly. It may be bad, if the parents have transferred control of the business, and the children change it in ways that distress the parents.
There are no specific laws limiting how much you can give away. However, there are some provisions that may limit how much one will want to give up. Ohio has no gift tax and few restrictions on making gifts. Most of the rules and regulations are federal.
It is important to note that for most purposes gifts are valued for taxes at "fair market value." In simple terms, "fair market value" is the price at which a willing buyer and a willing seller would agree to transfer the asset, with neither under the compulsion to buy or sell. Usually "fair market value" is significantly different from the basis.
Under federal law, any individual can give away up to $10,000 to any other individual in one year without having to file a federal gift tax return. The $10,000 is the "annual exclusion."
Someone giving away assets with an uncertain value, which may be $10,000 or more, may wish to have them appraised. Appraisals aren't required, but it may be necessary to prove that values are "fair market value," if audited by IRS.
Usually a person can make gifts much larger than the $10,000 annual exclusion without paying any gift tax or other tax on the transfer. A person must file an IRS form 709 anytime they make gifts totalling $10,000 or more to one person in one year.
For example, each parent can give up to $10,000 to each child. Similarly, a parent can make separate gifts up to $10,000 to the child's spouse, each grandchild, and anyone else, without filing a gift tax return. They can do the same thing each year.
The "unified credit" is another important part of federal law that applies to gift taxes and estate taxes.
Under the federal unified credit, every individual can transfer property with a "fair market value" of up to $600,000 to persons other than their spouse (spouse transfers discussed below), free of federal tax.
We each may transfer $600,000 by gift during our life or through our estate. Under federal law, each of us can transfer $600,000 tax free to anyone we wish. We can do it while we are alive by making gifts or at death through bequests. We can use part of the $600,000 to make gifts during life and any remainder to reduce federal estate taxes on the estate.
Every individual may transfer $600,000. Thus, a couple can transfer up to $1,200,000 by gift or through their estates, tax free. However, when the first spouse to die leaves all their property outright to the surviving spouse they reduce the tax free transfer to $600,000. (See OSU Extension Bulletin 595, "Estate Planning Considerations for Ohio Families" for a fuller explanation.)
For gifts, the $600,000 is in addition to the $10,000 annual gift exclusion. Since the annual exclusion is available each year, you use it first. For example, assume that a widow who had never used any of her "unified credit" gave one granddaughter $100,000 in one year. The first $10,000 would transfer tax free under the annual exclusion. She would have to file an IRS Form 709 telling the IRS that she made a gift over $10,000, but the remaining $90,000 is not taxed because of the "unified credit." She could make additional gifts up to $510,000 or pass that amount through her estate, federal tax free using the unified credit.
The $600,000 that each of us can pass tax free under the unified credit means most people don't pay federal estate taxes. Most of our estates are subject to state taxes, attorney fees and other probate costs.
Federal law places few restrictions on transfers between spouses. In general, a married couple can make unlimited tax-free transfers from one spouse to the other, both by gift and through their estates. They don't use any of their "annual exclusions" or "unified credit" to do so. Sometimes it is appropriate to make gifts between spouses to balance estates and make maximum use of the unified credit.
The concept that probably keeps more people from making gifts than any other is the necessity of giving up "control." In order for a gift to be completed (removed from an estate), the person making the gift must totally give up control and ownership rights to the property given away. Most of us simply don't want to give up control of our assets.
Retaining control can cause tax problems for the heirs of persons with large estates. If the person retains control or ownership rights, the total value of that property may be included in their federal estate.
We discussed "income tax basis" in some detail earlier in the section on selling the farm. One important point that bears repeating is that the person receiving a gift gets the previous owner's income tax basis, too. Therefore, when you give children farm products such as grain or livestock, they also receive your income tax basis (usually zero). Upon sale, they have the same taxable income you would have had if you had sold the products yourself.
Under current law a family will usually pay less taxes if children receive property through the parents' estates rather than by gift. The savings come from the "Stepped-Up Basis" rules discussed earlier. This is particularly true for parents with estates that will not pay federal estate tax (under $600,000).
Here we highlighted some basic tax laws relating to gifts between family members. Persons considering large gifts or sales of property should discuss the actual and potential tax implications with professional tax counsel before making the transfers.
Here are some additional considerations when the situation seems to favor the transfer of at least part of the land and buildings by sale or gift while the older generation is living.
Responsibility for and concern about maintenance and replacement of buildings and facilities can be transferred to the younger generation.
The younger generation gains an opportunity to build equity and take income tax deductions for interest and depreciation. They get a new basis for depreciation (if they buy). They can make needed improvements and gain the benefit from their use.
The operating generation may be bringing a third generation into the business, and they may need the security of a base of operations which is not subject to the whim of parents or other heirs.
Where several parcels of land are involved, and especially where they are separate or separable, one or more could be transferred, while other(s) are retained for the older generations's security. Long-term leases, options, etc. (discussed later) could be used with the retained parcel(s).
"Low basis is better than no basis." In the case of land, the advantage of a higher basis is upon sale, which may never occur, or not until some distant time.
Sales and gifts could be used together. The parents could sell on installments, then choose each year how much principal (and/or interest) they can afford to (and want to) give back. Other uses for the funds could include paying income taxes on the sale, supplementing retirement income, or making gifts to other children.
A combination of below-market sale price and/or interest rate, along with an extended-term loan, could be used to bring principal and interest payments close to cash rental rates.
Parents could sell a bare parcel with a higher basis to children, then make a tax-free trade of the parcel with the buildings in exchange for it.
A balance should be maintained among concerns for the parents' financial security, the children's economic opportunity, and minimizing income taxes.
Some people incorrectly believe that when they sell a farm they can avoid paying taxes on the sale by reinvesting the proceeds in another farm. In general, you cannot avoid income taxes by doing that, but here are five exceptions.
First, if you sell your residence and buy a new one of equal or higher value, within two years of selling the old one, you can avoid taxes on gain from the sale of the first home.
Second, taxpayers who are at least 55 years old, are allowed a limited one-time exclusion on the sale of a personal residence. Both rules apply to the portion of a farm sale that is the residence of the seller(s). We discuss this in more detail later.
Third, when property is involuntarily converted (stolen, destroyed by accident, or seized in condemnation proceedings) the insurance proceeds or condemnation award is not taxable when all the insurance or condemnation proceeds are invested in a similar property within prescribed time limits. Also, there is no tax if the amount received is less than the property's tax basis-a tax loss.
Fourth, it is also possible to make a tax-free exchange-where you trade property held for productive use in a trade or business for similar property. Usually, the potential seller asks the potential buyer to purchase property that the seller wants, so they can trade. There frequently is some tax if money exchanges hands or one party assumes another's mortgage. However, the taxes are frequently much less than a sale and a purchase. You need professional help to work out the details.
Fifth, there is a special kind or "tax-free exchange" where it is possible to make a deferred property exchange where you have 45 days to designate in writing up to three properties you would accept from the person who wants to get your farm. You have 180 days or by the date your tax return is due, including any extensions in the year the exchange takes place, to complete the trade. Again, this is not a do-it-yourself project.