Trying to understand the difference in 2 scenarios of gifting property

Question

I'm in the US.

I have 2 different scenarios related to gifting of a property and I'm trying to understand why scenario 1 feels legal and scenario 2 feels illegal. I can't put my finger on the fundamental issue that makes the 2 scenarios different.

Scenario 1: My friend gifts me his house in exchange for a small amount of $ (less than market value). This scenario seems legal.

My friend    ===> ownership ===>  me 

My friend    <===  $        <===  me 

Scenario 2: My friend transfers ownership of his house in exchange for a small amount of $ (less than market value) and I gift my friend (or his minor children) another chunk of $ that he pockets tax-free.

My friend      ===> ownership       ===> me
My friend      <===   $             <=== me
My friend/kids <=== tax-free $ gift <=== me

I feel like the difference is that in Scenario 1, there's a "winner" and a "loser." That is, there is a genuine cost borne by the the person who gives the gift and a genuine benefit by the receiver of the gift.

In scenario 2, there is no loser (except the government). But maybe there's more?

Answer 1

The following transaction involves two principles.

First, the step transaction doctrine. The step transaction doctrine is a judicial doctrine which treats a series of steps in a transaction as one for tax purposes. See Wikipedia for various judicial cases. Here, scenario two indicates that the gift portion (to friend/friends child) is being made as consideration for the home sale. The IRS is likely to treat the gift as part of the sale under the step transaction doctrine, with appropriate basis considerations (i.e., possible capital gains for friend, increased adjusted basis for you). If the gift is made to the friend's child the transaction would be restructured as: Sale to Friend for FMV followed by gift from Friend to Friends child.

Second, the first transaction is likely a bargain sale. See IRS Publication 544: "Bargain Sale: If you sell or exchange property for less than fair market value with the intent of making a gift, the transaction is partly a sale or exchange and partly a gift. You have a gain if the amount realized is more than your adjusted basis in the property. However, you do not have a loss if the amount realized is less than the adjusted basis of the property." Thus the friend may have realized capital gains if the money received is greater than adjusted basis. Additionally, the gift may affect the friends lifetime gift/estate exemption if greater than the yearly gift exclusion.

To address User “Orange Coast- reinstate Monica” comment of User “mhoran_psprep”: Gifts are specifically excluded from taxable income. 26 USC 102(a)

Answer 2

Scenario 2: My friend transfers ownership of his house in exchange for a small amount of $ (less than market value) and I gift my friend (or his minor children) another chunk of $ that he pockets tax-free.

The transfer of the money back isn't a gift. It only took place because of the first transaction. Therefore it will be seen as part of the earlier transaction.

Answer 3

My friend gifts me his house in exchange for a small amount of $

That's utterly and completely not the definition of "gift".

https://www.irs.gov/businesses/small-businesses-self-employed/gift-tax "You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return."

Moreover, the next sentence says, "If you sell something at less than its full value or if you make an interest-free or reduced-interest loan, you may be making a gift."

Thus, the difference between market value and "a small amount of $" is his gift to you.

Therefore, that scenario seems wholly illegal.

For the same reason, scenario 2 is also illegal.