Another Reason Not To Gift Residence

There are a lot of reasons NOT to give away your residence during your lifetime.  Many of those reasons have to do with relationship issues -- if you give your house to your son and then have a fight with him, will he kick you out? -- but tax concerns also play a part.  Here's a situation involving an acquaintance of mine -- the names and some details have been changed, but the main facts are accurate:

Joe Smith buys a house on the north side of Chicago in 1950 for $45,000.  In 2000, Mr. Smith makes a gift of the house to his only child, Marge, who lives there with (and cares for) him.  In 2005, Mr. Smith dies -- the house is appraised at $1.3 million. 

If Mr. Smith had owned the house at his death, Marge would have inherited it with a ("stepped-up") basis equal to the house's value at his death.  Marge then could have sold the house and paid no capital gains.  However, when Mr. Smith gifted the house to Marge, Marge assumed Mr. Smith's basis in the house -- let's say that's $45,000 (although improvements to the house may have increased that number a bit).  If Marge now wants to sell the house, she'll have a gain of around $1.2 million.  Some ($250,000) of that gain is excluded from taxation, but Marge will still have to pay tax on almost $1 million of gain.

One final point: gifting the house might have made more sense (at least from a tax perspective) if Mr. Smith had a bigger estate, since the estate tax rates are higher than the capital gains rates.  Excluding $1.3 million from your estate may be a good idea.  However, Mr. Smith had very few assets other than the house -- about $100,000 -- so his estate wasn't subject to estate tax at all.