Someone may have told you a story along these lines: Years ago, my grandfather bought waterfront land (fill in a desirable resort area) for $1,000. He built a vacation home on the property for $50,000 and his family enjoyed weekends and summers there.
When my grandfather retired, the house and adjoining property were worth $2 million. Then he sold it all to my parents for just $1. So, my parents paid virtually nothing for this $2 million property that was removed from my grandfather’s taxable estate. A genius move, right?
Probably, no. Despite what the storyteller says, there are potentially serious tax consequences to this technique under current federal tax laws. First, the IRS can and will consider the transfer a gift because the parents received it for far less than its fair market value. It is therefore subject to gift tax.
Second, and more significantly, the family forfeits the usual step-up in basis on inherited property. Instead, the property’s basis is what the grandfather paid for it – $1,000 – plus $50,000 in improvements, for an adjusted basis of $51,000. That means the parents are sitting on a whopping taxable gain of $1,949,000 if they sell the property sell.
Better approach: Don’t be swayed by mythical stories. The tax benefits of a $1 property sale are illusory. Assuming that the goal is to keep the property in your family, and that estate tax liability is not a factor, from a tax planning perspective it is generally better for the next generation to inherit the property and thus benefit from the step-up in base.