What are the tax implications of a sibling buyout…

[MeeshkaDiane]

Hello - Three siblings inherit the family home in Jan 2021: 1/3 Joe, 1/3 Peter and 1/3 Mary.  Now, Joe would like to gift his 1/3 share to Mary. Peter would like to gift 1/3 of his 1/3 share to Mary.  What is the best way to account for this and what are the tax implications?

[rjs]

Is this a homework exercise or a test question? This TurboTax community is not a homework help site. We're here to help people handle their own taxes. Where does MeeshkaDiane fit into the scenario that you described? What is your relationship to Joe, Peter, and Mary?

A gift is not a "buyout." In your scenario, no one is buying anything. Or did you omit some crucial details? Joe and Peter (not Mary) will have to file gift tax returns if the value of their gifted shares is more than $17,000 (for 2023).

To determine the effect on Mary's basis you need to know whether the estate used an alternate valuation date, the fair market value of the home on either the date of death or the alternate valuation date, and the fair market value on the date of each gift. You need dollar values, not just fractions of ownership.

There is no capital gain until someone sells something.

[MeeshkaDiane]

Hello - Okay, thank you. I am Mary. Trying to keep this simple.  Joe and Peter are brothers. One brother is gifting his full share. I would be buying out the other brother, but only for a portion of his 1/3 share. Say the house is worth $450k. Instead of me buying him out for 1/3 x 450 = 150, he would only charge me 100.  I think he would have to report a capital gains loss, offset by any capital gain on the FMV of the house that arose between the date of death (Jan 2021) and the date of sale (Aug 2023)?

The next big concern is my basis.  The basis would be based on the FMV of the home at today's date since the date of death has passed. How would this be calculated? I may not live in it and sell it next summer, which may trigger a large capital gain which would not make sense. 

[Carl]

There are other alternate valuation methods out there that may or may not increase your cost basis and help you. I'm not all that privy to the inner workings of these other methods, as they can get rather complicated and require a complex paper trail to substantiate if audited on it. Therefore, I'm keeping it simple.

Typically with inherited property, the cost basis is the FMV of the property on the date the previous owner passed. If audited on that valuation, some kind of documentation may need to be provided in order to support said valuation.

If each beneficiary gets 1/3 of the property then the cost basis for each of them is 1/3 of the previously established FMV.

If one beneficiary gifts their share to another beneficiary then that is a gift. If the FMV of their share is more than $17,000 then the giver (not the recipient) is required to file IRS Form 709-Gift Tax Return with the IRS. If the value of the gift is less than $11.5M (and I'm sure it is) then no taxes will be paid. But like I stated already, if the value is more than $17K the IRS reporting on form 709 by the giver is still required.

Say the house is worth $450k. Instead of me buying him out for 1/3 x 450 = 150, he would only charge me 100.

Using your numbers, they would still be gifting you $50K. Since that's more than $17K they would be required to file the form 709 with the IRS for the $50K they are gifting.

Assuming the most simplistic valuation method is used, your cost basis would be (using your numbers):

$150K for the portion you inherited plus

$150K for the portion gifted to you plus

$100K for the portion you purchased plus

$50K for the portion gifted to you.

Total would be $450K

[tagteam]

@MeeshkaDiane 

You can most likely forget about the alternate valuation issue since, per Section 2032, unless the alternate valuation decreases both the value of the gross estate and the estate's tax liability, it cannot be utilized.

Further, the 1/3 that you purchased from one of your brothers is controlled by Section 1.1015-4 (that 1/3 is considered to be part gift/part sale since you bought it below FMV from a close relative). As a result, your basis for that 1/3 would be the greater of the amount you paid your brother for the 1/3 or your brother's adjusted basis for the property at the time of the transfer.

See https://www.law.cornell.edu/cfr/text/26/1.1015-4

With respect to the remaining two-thirds:

The basis of the 1/3 you inherited would almost certainly be the fair market value on the date of death of the decedent.

With respect to the basis of the 1/3 you were gifted, you would typically need to know the donor's adjusted basis immediately prior to when the gift was made and also the FMV at the time the gift was made.

See https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/prope...

[MeeshkaDiane]

Hello! Okay, wonderful help. I am so grateful to all who replied.  I am posting this question to understand one more nuance.  Before I begin, I will RECAP based on the replied information to make sure I have understood all that you shared. Is the following correct?

In January 2021 upon the death of their mother, three siblings Peter, Mary, and Joe inherit a home (1/3 each) with a FMV of $450k. 

In July 2023, the FMV of the home is $525k. 

- Joe would like to gift his share to Mary.  $525/3= $175k.  Because the FMV $175k is more than $17,000, Joe is required to file IRS Form 709-Gift Tax Return with the IRS. 

- Mary pays Peter $125k toward his share of $175k. Peter gifts the remaining $50k of his share to Mary. Because the $50k is more than $17,000, Peter is required to file IRS Form 709-Gift Tax Return with the IRS. 

After these transactions in July 2023, Mary's basis is:

• $150k ($450k/3 at time of death)
• $175k Gifted from Joe
• $125k paid to Peter
• $50k gifted by Peter 
• $500k TOTAL 

Next question.  Mary does not live in the house, nor does she rent it out.  For each scenario below, what will Mary be obligated to pay for capital gains?

1. Mary decides to sell the house in less than a year for $535k. 
2. Mary decides to sell the house in less than 2 years for $535k.

[rjs]

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@MeeshkaDiane wrote:

After these transactions in July 2023, Mary's basis is:

• $150k ($450k/3 at time of death)
• $175k Gifted from Joe
• $125k paid to Peter
• $50k gifted by Peter 
• $500k TOTAL 

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That's wrong for the gifted portions. Since the FMV at the time of the gifts is more than the donor's basis, Mary's basis for the portions that she receives as gifts is the donor's basis at the time of the gift. Joe's basis for his 1/3 share is $150K. (Each sibling has the same basis for his or her original 1/3 share.) So Mary's basis for the share that is gifted by Joe is $150K, not $175K.

Peter's basis for the share that he gifts to Mary is (50/175) x $150K, which is $42,857, so that is Mary's basis for the share she receives as a gift from Peter.

[MeeshkaDiane]

Okay, is this the correct calculation for Mary's basis in July 2023?

• $150k Mary's basis  ($450k/3 at time of death January 2021)
• $150k Gifted from Joe ($450k/3 at time of death January 2021)
• $125k paid to Peter

• $42,857 Peter's basis for the share that he gifts to Mary is (50/175) x $150K

  $467,857 TOTAL 

[rjs]

I think that's right.

There are some assumptions being made here.

• No one paid any gift tax. They may have filed a gift tax return, but did not actually pay any gift tax.
• No improvements were made to the home from January 2021 to July 2023.

[MeeshkaDiane]

Okay, we definitely made improvements to the home say $25k. How does this impact the basis? 

[rjs]

"Okay, we definitely made improvements to the home say $25k. How does this impact the basis? "

Add to each person's original ($150K) basis the amount that that person paid for improvements. So Mary's basis for her original inherited 1/3 share will be $150K plus the amount that Mary paid for improvements. Then recalculate Joe's and Peter's basis for the gifted portions at the time of the gifts.

Joe's basis at the time of the gift will be $150K plus the amount that Joe paid for improvements. That becomes Mary's basis for the 1/3 share she gets as a gift from Joe.

Peter's basis at the time of the gift will be $150K plus the amount that Peter paid for improvements. Peter's basis for the share that he gifts to Mary will be (50/175) x ($150K + the amount that Peter paid for improvements). That becomes Mary's basis for the share she receives as a gift from Peter.

However, if adding the cost of improvements makes anyone's basis more than $175K, the FMV at the time of the gift, then it gets more complicated, and the basis might depend on the eventual selling price. See "FMV Less Than Donor's Adjusted Basis" in IRS Publication 551, Basis of Assets.

"what will Mary be obligated to pay for capital gains?"

You can calculate your capital gain based on an assumption about the selling price, but in order to calculate how much tax you will have to pay on the gain you would have to know the amount of your other income for the year of the sale and your filing status for that year. The amount of tax would also depend on things that you have no way of knowing now for a future year: what the inflation adjustments of the tax brackets will be, whether there will be any other changes in the tax rates, and whether there will be any changes in the applicable tax laws.

All of the gain will be long-term, no matter when you sell the house, because it was all acquired by inheritance.

[MeeshkaDiane]

Okay! Just to be clear, there is no capital gain until the house is sold to a third party? I have a second scenario to explore, but I will start another thread.  Many thanks again. 

[rjs]

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@MeeshkaDiane wrote:

Okay! Just to be clear, there is no capital gain until the house is sold to a third party?

---

That's not quite true. The whole house doesn't have to be sold. Any sale can produce a capital gain, including a sale of a partial interest. And I didn't say anything about a third party. (I'm not sure what "third party" means when there are already three parties involved.)

If the amount that Mary pays Peter is more than his basis for the share that he sells to her, Peter will have a capital gain. (If she pays less than his basis he has a capital loss, but he cannot deduct the loss because he sold to a related party.)

Thinking about this also made me realize that I was wrong earlier when I said that all gain would be long-term. The share that Peter sells to Mary is no longer inherited. Mary acquired that share by purchase. When she sells it, her holding period (long-term or short-term) for the share that she bought from Peter will depend on how long she has owned it after buying it from Peter.

This is obviously a complicated scenario. If you proceed with it, you should probably consult a local tax professional. The three of you each have to go to a different tax pro because your interests are not the same. It would be unethical for one tax pro to advise more than one of you.

[MeeshkaDiane]

Okay, to clarify regarding this scenario:  the only sale would be Peter selling part of his July 2023 share (525/3=175) to Mary as follows: Mary pays Peter 125. Peter gifts Mary 50k. Can you advise how Peter would account for this aspect of the transaction? Mary's basis would be 125+ (50/175) x Peter's adjusted Basis at the time of our Mom's death?

[rjs]

Peter's capital gain will be the amount he receives from Mary, minus his adjusted basis for the share that he sells to Mary. The tax pro that he consults will figure it out for him. His gain will be long-term because he inherited the share that he sells to Mary.