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I'm in a bit of a conundrum here:

  1. My sister owns an investment property outright (no loan on it...)
  2. She lives with me in my primary residence.
  3. Now, my family and I are moving to another house, with my sister continuing to live in the current property. The property does have a loan on it, under my name.
  4. She is helping me furnish a part of the down payment on the new house, by taking a home equity credit loan on her investment property.

Now, the questions:

  1. For my sister - Does she owe Gift Tax? The loan amount is around $70,000.
  2. Are there any tax implications for me?
  3. Finally, is this the most efficient route? What if we sell the property that she's living in (my former primary residence) in 2 years? I will likely use the proceeds to pay her equity loan back. Will I be hit with the capital gains tax and then gift tax?
  4. Is it better for me to sell the property to her and pay the recordation/transfer taxes?

If it matters, all properties are located in the state of Maryland.

  • Who will pay off the $70K loan? Will she? Is the really a gift or a loan to you? – JoeTaxpayer Sep 19 '13 at 19:23
  • She will be making the payments on the 70k loan. It's a gift to me – rs79 Sep 19 '13 at 19:51
  • And what is the nature of her staying in your old house? She is a tenant and you have to charge rent. If you charge below-market rent, you still have the imputed income. – JoeTaxpayer Sep 19 '13 at 20:40
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The fact that she is borrowing against her income property to furnish you the money seems to me to be a distraction here. Where she gets the funds is immaterial. What matters are the transactions between her and you. The rest of this answer presumes that avoiding owing any gift or estate taxes is the most important consideration, since that seems to be the premise of your question.

If she outright gives you the $70K, part of the gift (she can give you and your spouse up to $14K each per year, for a total of $28K/year without any tax consequences) will be subject to gift tax or the lifetime estate exclusion (her choice). If in some later year, you give her back the $70K, that will subject you to the same gift tax/estate exemption issues.

If the money she is providing for the down payment is a loan to you (in other words, you intend to pay it back at some future date), you should structure it as such and document it.

Example: My in-laws (or more precisely, their family trust) are our mortgage lenders. In order to avoid any gift tax issues, we found the lowest advertised mortgage interest rate at the time of the loan, and set it up at that rate. We make the payments and take the deduction. My in-laws pay taxes on the interest income. This is no different than borrowing from any other lender, except for the fact that the loan asset is part of an estate we may someday inherit (far in the future, it is to be hoped). The IRS has no problem with this.

You could presumably structure a loan from your sister as interest-only with a balloon payment due when you sell the property. Just have proof that you paid her, and she would need to declare the income on her taxes. The only problem I can see with this is that your bank might not be too happy that you have this other loan, as it would increase your debt/income ratio. She could also not forgive the loan without the same gift tax implications.

As you say, you could also sell your current residence (also hers) to her and just use the capital gains exclusion for primary residences. Assuming your equity in that house is >$70K + transaction fees, you'd have enough for the downpayment, and all the transactions would be quite conventional.

Or, you could sell her a share of the property equal to $70K/(current value of the house), but this would need to be allowed by the current lender, which might get complicated. You would also need to share the proceeds of any future sale with her in proportion to her interest in the property.

All these options have pitfalls, but selling her the current house outright is probably the most straightforward. On the other hand, if neither her estate nor yours is likely to get close to the ~$5M exclusion limit, just do the transactions as gifts, file the lifetime exclusion forms, and don't worry about it.

  • Thanks so much for the exhaustive options! The problem with selling is the transaction costs will amount to about $9000, which we would prefer to avoid. Now that the gift tax implications are clearer, I may have her write three $14000 checks for my wife, son and me, and the remainder $28000 to be claimed in her tax returns counting against the lifetime exclusion. – rs79 Sep 19 '13 at 16:47
  • I am not a lawyer, tax accountant, or financial professional, so take anything I say with a pound of salt, but I would be careful about taking a gift to your child and using it that way. It might be fine, since having a home is definitely a benefit to the child, but since the child will presumably not be named as a joint owner of the property, it might not be quite kosher. Consult a pro on questions like this. Is the $9K just for taxes, title paperwork and such? I assume you would not need to pay any commissions to agents. – Rick Goldstein Sep 19 '13 at 17:25
  • Correct. The 9k will be the closing costs and no commissions due. However, there are hoops to jump for my sister to secure loans and to put 20% down AFTER taking a 70k loan on her investment property. Figured, a gift would likely be most economical, taxes-wise. Also, we don't anticipate her estate crossing the ~$5 million threshold. – rs79 Sep 19 '13 at 19:57

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