The 18 Gift and Estate Tax Questions You Must Ask Before Helping Your Child (or Grandchild!) Buy a Home in Hawaii
An Introduction to this Gift and Estate Tax Article:
This article boils down the major tax situations you need to be aware of when you help someone buy a home. As with anything tax-related, this article is quite technical. But, this should give you a good background in the materials. I view this guide as a decently-simplified, but relatively comprehensive guide to Federal Gift Taxes, Federal Estate Taxes, and Hawaii Estate Taxes.
Now, you may be asking, why is a Realtor-Broker writing a detailed article on gift taxation and estate taxation? Well, years before I became a realtor, I became a real estate and estate planning attorney* (and as of the date of this article, January of 2022, I am still licensed as an attorney in both Illinois and Hawaii). Anyway, in my estate planning background, I have written and revised over 200 trusts, and as a real estate attorney I have completed over 1,500 buy and sell transactions for both residential and commercial properties. While I am not an accountant, I’ve fielded a lot of questions over the years by folks who are concerned about paying additional taxes by mistake. Folks who have the financial ability to help their kids or grandkids also often want to help out by helping with a down payment, or even by buying their kids or grandkids a house. Heck, it is common in many part of the world, and even in some parts of the USA, for families to give a house as a gift upon a marriage.
Very important note: this tax article is meant to be an information source, but this article is not legal or tax advice—you should always run your specific situation by a tax attorney or tax accountant! However, this guide should provide some piece of mind and a bit of knowledge to folks who just want to know whether there is a high likelihood or low likelihood that they will have to pay a bunch of tax based on helping out the kids and grandkids.
The Layout of this Gift and Estate Tax Article:
Part 1: General information on Gift and Estate Taxes
The first set of questions in the Q+A go into the background information you need to understand the Estate and Gift Tax issues. It outlines the different types of taxes, both Federal and State, that you could run into, and discusses the application of yearly tax exempt gifts to real estate transactions.
Part 2: Information to help individuals with large estates (over $5.49 million net value) reduce taxes
The remaining questions are specific to people with high net worth in terms of both liquid and illiquid assets, or who have large estates they expect to leave behind when they eventually pass away. This section goes through various methods and devices a buyer can use to reduce taxation in consultation with a tax attorney and an accountant. The methods discussed are largely complex, but for individuals with large amounts of assets, knowing the most commonly available methods to reduce taxation is an essential. Many businessfolks and other high net worth individuals are stuck talking to expensive consultants to even get the basic information they need to make decisions. Hopefully, this section fills a gap in available information and helps individuals and trustees more clearly identify their buying strategies.
Before we get started, here is an open offer to contact me with targeted questions:
If you want to chat about your specific situation, please give me a call or an email where we can set up a conference to talk about your real estate goals. Given the amount of time it may take to discuss gift and estate taxation issues, I limit these consultations to only two consults per week. Especially for high net worth individuals, taxes often help define what one can and cannot do with their finances. Often, it takes a detailed look, some spread-sheeting, and some serious number crunching to figure out the best moves when you are looking to put money into real estate or other venture.
If you would like to call or set up a consultation, here is my contact information:
Joey Furlett, JD*, Realtor-Broker, REI
WeChat / Insta / TikTok: HawaiiHome8
REALTOR-Broker # RB-23572
Real Estate Investing Certification
Luxury Homes Certification
(*Joey is licensed as an attorney in both Hawaii and Illinois, but to be clear, he is not practicing law in his role at Hawaii Life)
Without further ado, the Gift and Estate tax Q&A…
☆☆☆ PART 1 of Joey’s Gift and Estate Tax Q&A: Can I give my kids or grandkids a down payment or a house without having a tax problem? ☆☆☆
Hint: The answer to this tax question is a lot more questions! That is why this article is a Q&A guide!
1. Can I help my kids either buy a house or pay a down payment without having a tax problem right now?
Answer: In general, you shouldn’t have an immediate tax problem if you give your children or grandchildren either a house or a down payment. However, you will need to work with an accountant to file the right forms (usually IRS form 709) to make sure you stay in compliance. Gift tax can be huge, but if you work with your accountant before you finalize your giving plans you shouldn’t have to pay gift taxes during your lifetime. Gift taxes are usually paid from your estate, and the amount you pay will depend on two things: 1) the size of your estate, and 2) how much you have given to each person who receives a gift.
2. Is a really big gift like a house or a down payment considered to be income for tax purposes?
Always run your situation by your favorite accountant or tax professional, because sometimes gifts structured in the wrong way can become income. However, simple answer: Usually no, gifts are not considered income. Fact is, if your gift is a regular gift with zero strings attached, no kickbacks, and nothing fancy, the IRS usually takes the position that it is not income. Now, if you have some sort of funny arrangement where you need to do something in order to receive a gift or something like that, then it is possible that it is income.
As a general rule of thumb, and I’ll talk about this way later in the article (see the section on “step-doctrine” in Question 14), the IRS takes the position that what matters is the “substance” of a matter, not the “form.” In other words if you had a contract where it says “If B paints all of A’s house within a week, then A agrees to give B a gift of $5,000.” You may have used the word “gift,” but the IRS will usually see this as a pretty clear contract of employment. If you have a conditional gift situation, please run it by an attorney. As stated above, this article is not legal advice, just an educational guide for homebuyers.
3. Does a person getting a gift ever need to pay taxes on it?
Simple answer: It isn’t super likely.
Complex answer: If the Giver dies, is required to pay taxes on the gift because they exceeded the Lifetime Gift Tax Exemption, and the Giver does not pay or refuses to pay, then Giftee may have to pay the taxes. Also, there are special scenarios where the Giftee agrees to pay the tax. But honestly, these situations are exceedingly rare. In fact, don’t be surprised if your favorite accountant has never even heard of a situation where a gift-receiver pays taxes. If you need advice on one of these oddball scenarios, then you probably need to contact a well-respected tax attorney for targeted advice.
4. How much can I give to my child before I start having tax problems?
The Super Simplified Answer about Tax Thresholds and Forms:
If you are not a millionaire and will never be a millionaire, have never given away millions, and will not be giving away millions, then you may not need to worry about gift taxes as of 2022. But there are a lot of changes happening with gift tax exemptions. Based on how the rules work now, if you have, you would need to fill out IRS form 709 with your accountant to document the gift. But, given the high price of real estate in Hawaii, it is possible that in the future many homeowners may have to deal with gift tax issues. For more info on that, keep reading this article!
The Slightly More Complex Answer about Tax Thresholds and Forms:
The answer as to how much you can give before triggering the possibility of extra taxes changes every year, and it is tied directly to the IRS tax code. For the year 2022 a person may give $16,000.00 to each individual during the year before worrying about gift taxation, in general. However, the person giving the gift may still need to declare it on IRS Form 709. Because of the interplay of tax rules, however, gifts in excess of the annual gift tax exemption may not actually subject you to a tax problem. That said, if you have a rather high net worth or have a large estate you will leave behind, you may end up with a gift or estate tax problem, but it depends on how your estate lines up with certain wealth thresholds that change year by year.
5. Wait, what types of gift and estate taxes are there for buyers in Hawaii, anyway? How do they work?
Okay, for folks who do not know taxation (most of us), there are three big things we have to watch out for when giving money:
- Annual Federal Gift Tax exemptions
- Lifetime Estate Tax Exemptions
- State of Hawaii Estate Taxes
Since these three tax types work with each other, you have to be equally aware of each one, and how they work together. **Warning! It gets a bit technical!** (Actually, it gets really technical—that is why I offered in the beginning of the article that you could just reach out to me and we could chat through things a bit.)
6. What is the Annual Federal Gift Tax Exemption?
The Annual Federal Gift Tax Exemption is the amount a Giver can give to each an individual Giftee in a certain year without worrying about having an impact on their “Lifetime Estate Tax Exemption.” That means that if you give more than this amount, that it may subject you to taxes on the gift.
Wait…Gift Tax??? I can get taxed by giving a gift?
Yup, the Federal government very much likes to tax gifts. Gift taxes are high and to the government they are a delicious way to get revenue.
What happens if I give a gift more than the allowed amount for a year?
Well, then it may subtract against the Lifetime Estate Tax Exemption amount, and if you use up the Lifetime Estate Tax Exemption then you can have tax rates as high as 40%.
So, what are the ground rules on this tax? What is the threshold?
The Annual Federal Gift Tax Exemption amount is $16,000.00 per year from Giver to each Giftee in 2022. Basically, a giving party (the “Giver”) can give a gift to anyone they want, and Giver gets an annual exemption of $16,000.00 for the year 2022, for each person getting a gift (the “Giftee”), whether or not that person is related to the Giver.
What happens if I give more than this amount?
It will probably eat into the amount of your estate you can give away at your death without being taxed (your Lifetime Estate Tax Exemption). Hawaii also counts the dollars that have been given over the Annual Federal Gift Tax Exemption, and these are counted against the threshold for paying Hawaii Estate Taxes. (Don’t you just love how everyone wants a piece of your money?)
Are the thresholds going to stay the same each year for the Annual Federal Gift Tax Exemption?
The thresholds and rules may change at any time. However, the one thing that stays the same is that there is usually an exemption for some dollar amount of gifts. I do not have a crystal ball regarding the IRS, but I don’t see the IRS ever removing the Annual Federal Gift Tax Exemption completely. The threshold, however, does shift. From 2018 through the end of 2021, a Giver could give $15,000.00 to an individual (related or not related), the Giftee, each year before having to worry about gift taxation. Next year the Gift Tax Exemption amount could go up, go down, or stay the same.
7. What is the Federal Lifetime Estate Tax Exemption?
In short, this is the limit on how much you can give everyone you give things to, without paying taxes. If you have to worry about this amount, then you are probably rather wealthy. Maybe you already know about this topic. Either way, this guide should be a decently fun read.
What are the tax rates if I am subject to the Estate Tax?
The rates vary from 18% of the estate value over the exemption to 40% of the estate over the exemption. The graduation of tax rates happens quickly, though, and any amount exceeding 1 million dollars over the Lifetime Estate Tax Exemption will usually be taxed at over 40%
Wait, is this the same thing as the Lifetime Gift Tax Exemption?
Okay, before we get into anything else, just be aware that tax professionals are often a bit confusing when they chat about the Lifetime Estate Tax Exemption. Oftentimes, tax professionals will refer to it as the “Estate Tax Exemption” or the “Lifetime Gift Tax Exemption.” This confusing terminology persists largely because these rules only really get triggered by folks in the higher net worth categories. A tax professionals can go a lifetime without ever having to deal with an estate tax issue in many states, just due to the small amount of people with such a high net worth. The differences in terminology also likely have to do with the differences in application. If an accountant has to file taxed on a 15 million dollar gift that accountant is likely to refer to it as a Lifetime Gift Tax situation, and one who is dealing with an estate is likely to refer to it as a Lifetime Estate Tax situation. But they are really just two names for the same concept viewed from different angles.
So, what is an Estate Tax? Is this different from an Inheritance Tax?
An Estate Tax is a tax paid by an estate before monies can be distributed to the beneficiaries. Putting it simply, these are taxes that have to get paid before anyone takes money from an Estate) On the other hand, Inheritance Taxes are paid by the beneficiary (the one who gets the monies). There are currently no Federal inheritance taxes.
What is the threshold for the Lifetime Estate Tax Exemption in 2022?
As of 2022, the Lifetime Estate Tax Exemption is 12.06 million. That means that if you die this year and leave an estate worth more than 12.06 million*** this year, then you likely need to be worried about gift taxes.
But… as Bob Dylan said, “The times, they are a-changing!”
☆☆☆The rules are changing and are changing quickly!! In 2026, the lifetime estate tax exemption threshold is set to be halved to about 6 million dollars—this will have a direct effect on annual gift tax issues as well! If you expect to pass away after 2026 and you have more than 6 million dollars in liquid and nonliquid assets, please contact a Tax and Trust attorney for advice!☆☆☆
With dollar amounts in the multiple millions, how can Lifetime Estate Tax Exemption issues even possibly affect me when I buy in Hawaii?
While there aren’t many folks in the US that have an estate exceeding 12.06 million (again, it is getting halved to about 6 million in 2026), if your estate is bigger than this multimillion dollar threshold the bills rack up pretty quickly. In Hawai’i, due to the high value of land and real estate, a person with just a few properties could easily exceed the Lifetime Estate Tax Exemption limits
Joey’s Chart for Federal Estate Taxes (Accurate as of January 1, 2022):
|Estate Tax Rate||Amount over the Federal Lifetime Estate Tax Exemption||Dollars of estate tax paid (Formula)||Maximum tax paid per bracket|
|18%||$0 to $10,000.||$0 +
18% x number of dollars over $0.00)
|20%||$10,001 to $20,000.||$1,800 +
(20% x number of dollars over $10,000)
|22%||$20,001 to 40,000.||$3,800 +
(22% x number of dollars over $20,000)
|24%||$40,001 to $60,000.||$8,200 +
(24% x number of dollars over $40,000)
|26%||$60,001 to $80,000.||$13,000 +
(26% x number of dollars over $60,000)
|28%||$80,001 to $100,000.||$18,200 +
(28% x number of dollars over $80,000
|30%||$100,001 to $150,000.||$23,800 +
(30% x number of dollars over $100,000)
|32%||$150,001 to $250,000.||$38,800 +
(32% x number of dollars over $150,000)
|34%||$250,001 to $500,000.||$70,800 +
(34% x number of dollars over $250,000)
|37%||$500,001 to $750,000.||$155,800 +
(37% x number of dollars over $500,000)
|39%||$750,001 to $1,000,000.||$248,300 +
(39% x number of dollars over $750,000)
|40%||More than $1,000,00||$345,800 +
(40% x number of dollars over $1,000,000)
|Sky is the limit!
For more info, please click here.
8. What about State of Hawaii Estate Taxes, how do those affect me?
First of all, please be aware that Estate Taxes vary from state to state. In Hawaii there is a progressive tax on estates that ranges from 10% for small estates, to 20% or estates over $10 million. The biggest difference between the Hawaii and Federal taxes is that Hawaii’s taxes start when the estate is larger than $5.49 million. Essentially, there is a $5.49 million State of Hawaii Estate Tax Exemption. In other words, the Hawaii Estate taxes will start up before there the Federal tax level. Adding to the potential tax burden, Hawaii also looks at your Federal tax forms for Annual Gift Tax Exemption filings. Any dollars you give over the Annual Gift Tax exemption are then counted against the $5.49 million threshold of the State of Hawaii Estate Tax Exemption
Example for Hawaii Estate Tax Exemptions:
You give your child a house worth $1,016,000.00. Because this is $1 million more than the Annual Gift Tax Exemption. In general (there are exceptions), that $1 million would count against the $5.49 million threshold. ($5.49 million – $1 million = $4.49 million). Therefore, giving that particular house would subject your estate to State of Hawaii Estate Taxes if you die with only $4.49 million in total estate value.
Does Hawaii have an Inheritance Tax too?
Hawaii, as of the time of this article, does not have an “inheritance tax.” As I mentioned in question #5, an Estate Tax is a tax paid by an estate (usually after someone dies) before monies can be distributed to the beneficiaries. On the other hand, Inheritance Taxes are paid by the beneficiary (the one who gets the monies).
Joey’s Chart for State of Hawaii Estate Taxes (Accurate as of January 1, 2022)
|HI Estate Tax Rate||Value of the Estate over $5,490,000.00 minus aggregate amounts over the Annual Gift Tax Exemption||Dollars of estate tax paid (Formula)||Maximum tax paid per bracket|
|10%||Between $0 and $1 million||$0 +
10% x net estate value
|11%||$1,000,000.01 to $2,000,000.00||$100,000 +
(11% x net estate value over $1,000,000)
|12%||$2,000,000.01 to $3,000,000.00||$210,000 +
(12% x net estate value over $2,000,000)
|13%||$3,000,000.01 to $4,000,000.00||$330,000 +
(13% x net estate value over $3,000,000)
|14%||$4,000,000.01 to $5,000,000.00||$13,000 +
(14% x net estate value over $4,000,000)
|15.7%||$5,000,000.01 to $10,000,000.00||$18,200 +
(15.7% x net estate value over $5,000,000)
|20%||$10,000.000.01 and greater||$1,385,000 +
(20% x net estate value over $10,000,000)
|Sky is the limit!
For more info, please see Hawaii Form M-6 (Link good as of January 2, 2022)
9. What about State of Hawaii gift taxes? How much will I owe in those?
Good news! As of the time of this article, January of 2022, there are no state gift taxes in Hawaii!! Could that change in the future? Sure, but state gift taxes aren’t particularly common in the USA. Where there are any gift taxes, they usually only apply in select circumstances.
10. So, if I have less than $5.49 million and haven’t given away large sums of money I don’t have to pay any taxes even if I give my kid or grandkid an entire house?
As a general rule of thumb, if you add together all of your assets and all of the monies you have given away, and the total is less than $5.49 million, then it is highly unlikely that you will have to pay either Federal or State Estate or Gift Taxes. If you have more than $5.49 million when you add together all the monies you have given away and your current estate value, then you need to have your estate plan looked over more carefully by an accountant to make sure whether you have ever exceed the Annual Gift Tax Exemption. Whatever monies you give over the year 2022 $16,000.00 Annual Gift Tax Exclusion will need to be declared on the IRS form 709 and it will likely count towards your Federal Lifetime Estate Tax Exclusion and also against your State of Hawaii Estate Tax Exemption. That said, if you do not plan to leave behind a multimillion dollar estate, applying these dollars against your Federal and State Estate Tax Exemptions may not matter.
11. Okay, I want to give my grandkid the house. I have heard things about the generation skipping tax. What is the generation-skipping tax, and what does it mean?
Generation skipping tax is a funny concept. Technically it is different from the Lifetime Estate Tax Exemption, and originally had a threshold different than this exemption, but in recent years (possibly for simplicity) the IRS decided to make the Lifetime Estate Tax Exemption and Generation Skipping Transfer Tax use the same values of exempt gifts before going into higher tax brackets. So, as of 2022, for our purposes (this isn’t quite exact, but this is how it works conceptually), they each work with the same pot of funds. If you have exhausted your Lifetime Estate Tax Exemption, therefore, you have also hit the threshold to trigger the Generation Skipping Transfer Tax (GST). To be frank, this is a background article and legal advice article, so my advice (I probably sound like a broken record at this point) is to ask questions about the GST to your accountant. That said, do not be shocked if your accountant refers you to a different accountant or tax attorney because a true analysis of GST can get really, really messy.
Here are two sources to look at regarding GST:
An article from a major law firm that is more up to date on Generation Skipping Tax
An article from 2009 in the Journal of Accountancy that discusses the mechanics and history of this Generation Skipping Tax
☆☆☆ Congratulations! You have reached the end of Part 1 of Joey’s Q&A Guide to Gift and Estate Taxation ☆☆☆
☆☆☆ PART 2 of Joey’s Gift and Estate Tax Q&A: What questions do I need to ask if I have an estate or net worth over $5.49 million, but want to avoid paying excess Estate Taxes? ☆☆☆
12. What about if I have over $5.49 million but I don’t want to pay estate taxes later?
Well, in short, you need to carefully set up your finances and plan any gifts you give so as not to trigger extra taxes. You will likely still pay some tax, but you can avoid some taxes by careful planning. The next few questions will get into potential methods you can use to potentially reduce estate and gift taxes, but they will need to be run by an accountant and probably also a tax attorney. Again, this article is informative, but it isn’t legal advice or accounting advice.
13. Is there a way to give more than $16,000.00 in 2022 as a down payment for my child without having a tax problem if I have an estate valued at over $5.49 million?
Not really, to be honest. Unless you use methods that make the $16,000.00 something that is not a gift. There are certain categories of gifts that are not considered “taxable gifts,” but down payments fit within the taxable category. For information on what gifts are not taxed by the IRS, please check out this link.
14. What if I have high net worth, I still want to pay for my child’s down payment or house, but I don’t want to eat into my Lifetime Gift Exemption? Is there a way to do it?
The answer is a resounding “maybe.” If you have a situation falling into this category, I strongly advise you to consult with both a tax attorney and an accountant. If you need this kind of specialized advice to avoiding eating into the Lifetime Gift Exemption by structuring your gifts, any methods must be done by professionals.
So… what methods are there to do this…?
Well, there are three main methods that can be used, and they may even be used together in some circumstances: setting up a trust, putting a parent on the loan/title, or doing a family loan.
Method 1: You may need to set up a trust.
A trust is an arrangement where a person with assets (the “Grantor”) gives money to third party (the “Trustee”) to hold or use the money on behalf of one or more recipients (the “Beneficiaries”) who will get the benefit of the trust monies. You may need to set up one of two types of trust:
1) A revocable trust (one you can modify):
these have less tax benefits, in general. However, they can help you allocate gifts over time to avoid estate tax triggers
2) An irrevocable trust (a trust where, after you set it up, you no longer have direct control of your money):
these trusts have significant tax benefits, depending on the structure, but this comes at the major tradeoff of no longer having direct control, or perhaps any control, over your own monies. An irrevocable trust absolutely must be put together with a very experienced attorney with a strong tax and estate planning background. If these trusts are done correctly, they can preserve the estate. If they are done sloppily, these trusts can be a huge burden and could theoretically leave you homeless and with no access to any of your own hard earned money.
Method 2: The parent or other Giver may need to be on title and/or on the loan.
For this type of setup, there may be a detailed numerical analysis of how much “benefit” the “Giftee” is getting from the “Giver” each year. As discussed before, the first $16,000.00 (in 2022) given by a Giver to any specific Giftee goes towards the Annual Federal Gift Tax Exemption. This exemption applies to each individual Giftee.
What does this analysis look like?
In short, it would look at whether the benefit to the Giftee would exceed $16,000.00 per year, and whether the benefit to the Giver was enough to offset whatever monies are given to the Giftee. Honestly, it is rather complex and would likely require the assistance of a tax attorney and an accountant to hash out the details together. It may also require the use of a CMA (comparative market analysis) by a realtor to determine the value of the use of a particular amount of space (for example, the rental value of particular rooms in a house)
So, what happens if, as the parent, I am just on the loan, but I am not on title?
Well, it most likely depends on whether you are actually paying towards the loan. If you are there as a co-signer there is likely no problem with gift taxation. But, if you start paying towards the loan when you are not on title, then that is almost certainly going to be deemed a gift when you pay. This is because you as the parent are not taking any benefit because you do not have ownership rights to the property. That said, please check with an accountant and a tax attorney regarding the specifics of the situation.
Well… what if I go on the title, and also pay off the mortgage?
You will want to check with your favorite tax attorney, but most likely what matters here is whether you are actually gaining use benefits of the property. Depending on the analysis used, you may also have to show that your contribution is in proportion to the benefit of use you have in the property. It is quite likely that, to the extent that you pay more towards the loan than the benefit you actually receive, you will be subject to gift tax rules. In other words, you likely won’t have a tax problem with fair market use of the property. But, if you are paying more than your fair market use, then it may be a gift. Again, run it by an accountant or tax attorney.
Method 3: You may want to set up a Family Loan for your child
A Family Loan is where you loan your child money at a statutorily-defined interest rate usually far below the regular “street rates” for mortgages. These can be done as a “purchase money mortgage,” meaning that they can be used for all or nearly all the funds needed to buy the house. Under a Family Loan arrangement, the child pays you back with interest set at a statutory rate of by the IRS on a monthly basis based upon the length of time the loan will last. These rates are referred to as the Applicable Federal Rates. By using a Family Loan, you can avoid a mortgage lender, avoid a gift, give your child or grandchild a super low interest rate, and still act as a resource as they buy a home. For a Purchase Money Mortgage through a Family Loan, you will need to get a real estate attorney involved to write up the agreement and you will still want an accountant to give it a look-see.
There are 3 loan rates published monthly:
- For loans under 3 years
- For loans more than 3 years but less than 9 years
- For loans that last more than 9 years
Since the rates change monthly, it would be unhelpful for me to post the rates for the month this article first comes out. Instead, I will provide the link that I personally use when I have talked to people about the these rates.
Applicable Federal Rate Resource (Link good as of January 2022)
15. So…is there a way to still give my child money towards this Family Loan Purchase Money Mortgage?
The short answer is…you really need to check with your tax attorney and your accountant, probably in a 3-way conference, to make sure you do not accidentally violate laws if you decide to try to both give your child a Purchase Money Mortgage and also try to give your child gifts to pay for the home. Paying less gift and estate tax is good for high earners and those with large estates, but not if it means violating the law or potentially triggering huge tax liabilities.
On a technical level, the mortgage may be a standalone, and is deemed a Fair Market Value loan by the tax code. Theoretically, you can give anyone up to the annual gift tax exclusion each year (or forgive a debt up the value of the Annual Gift Tax Exclusion), but in practice it may subject you to some serious liabilities. In general, the IRS is more concerned with “substance over form.” What do I mean by substance over form? Well, this is a phrase the IRS uses as a one-sided and self-favoring legal argument. The IRS takes the approach that regardless as to the way a tax reducing maneuver is done, the IRS will re-characterize itemizations and deductions. In this situation, using these methods together will likely trigger what is called the step-transaction doctrine.
What is a step-transaction, and why would that matter for real estate?
Under this doctrine, if you have a multi-step process you use to avoid taxation, the IRS may treat the steps as a combined single transaction. In order to look at this the IRS looks at a series of factors, including how integrated each step of a transaction was towards achieving a tax goal. This type of IRS argument is often seen in loans used for business reorganization, where a taxpayer claims that they have made a non-taxable transfer and the IRS believes that this reorganization is a taxable event.
Likewise, the IRS can also try to pursue folks for “structuring” payments intentionally to avoid taxes. So, if you do decide to use more elaborate methods to reduce taxes, then you have to be very careful in your documentation, otherwise you might find yourself on the wrong side of an IRS criminal probe, or paying more taxes and IRS fees than you would have without your tax reduction strategies. I know this is not the most fun thing to mention in a happy article about how to help your kids and grandkids. That said, while we all want to help our kids, we have to be careful not to harm ourselves as we help the next generation. Whenever you try to reduce your taxes, please seek help from a practicing tax attorney and an accountant.
16. Well, what about if I make a contract with my child saying that if he gets good grades in college I will pay the mortgage or buy a house for them. That surely isn’t a gift, right? What about that???
WARNING: DOING THIS MAY TRIGGER HIGH TAX RATES
**Please talk to your accountant**
Well, it may or may not be a gift depending on how it is worded. If you want to go this route, definitely have an attorney draft everything. You can easily shoot yourself in the foot with a wrong word. But, you may not want to do this. Why not? Well, this may end up as an employment contract rather than a gift. If that is the case, your child will have to pay income tax on the amount of benefit they received. If you pay the mortgage, the yearly payment will be taxable. If you buy a whole house on a contract like that, your child may end up paying high tax bracket income taxes. In Hawai’i, where a single family house can easily exceed 1 million dollars, that could be deemed 1 million dollars of income for a single year. Using 2021 income tax levels, that could result in paying a 46.4% income tax rate, which would hit your child with a tax bill of nearly $464,000!!!
17. What if I buy a property, sell it to my children, and lease it back to pay the mortgage?
WARNING: DOING THIS MAY TRIGGER HIGH TAX RATES
**Please talk to your accountant**
If done correctly, it might reduce estate taxes, but it may trigger income taxation for your children. Income tax can be huge and may make this not a viable method. Check with a tax attorney and an accountant. This is a very complex method and will require CMA’s lease documents, multiple escrows, and possibly some light trust work. You would need to ask your tax attorney and your accountant if this is a possibility, and then, very likely, the attorney and accountant would need to plan this out together. And if you do it wrong it could also trigger the step-doctrine we discussed, above
18. Okay, I have read this article in its entirety and now I feel more confused than ever. I just want to make sure I don’t do something silly and cause myself to pay extra taxes. What is my next best step?
Honestly, that’s why I threw my contact information on the top of this article. The analysis gets really specific to each person and their estate plans. Most likely, we can chart out what your estate looks like and get you to the point of, “this is probably the right way to do things, but you need to run this by your tax advisor or tax attorney.” Feel free to shoot me a text at 808-818-8811 if you want to set up an appointment and see how I can help you achieve your purchase goals with the least risk possible.
A last personal note from the author:
If you made it to the end of this highly technical argument, I applaud you and thank you. On a personal note, this article took a couple weeks of drafting time. As a person who works as both a Realtor and Attorney* (*again, I am not an attorney at Hawaii Life, but I have a small family-run practice I work at that is technically based out of Illinois), you can imagine the odd looks and comments I have received as I poured countless hours into this article. This article was, quite simply, a labor of love. For buyers, I sincerely hope that this article is helpful to you as you develop your estate plans and buying objectives. For my fellow Realtors who read this article, I hope this information can help you as you advise your own clients.
If I can be a resource on anything, please reach out. In my legal career, I have advised on these types of matters numerous times (over 200 estate plans under my belt and over 1,500 real estate transactions), and in my second simultaneous career as a Real Estate Broker, I wanted to make a guide that was approachable. I realized that outside of various heady legal and accountant circles I have never seen a a complete guide to these complex tax matters that would be readable without a license or an advanced degree. If you have any suggestions for this article or have additional questions you would like me to answer in a future post, please do reach out and let me know.
Thanks again for your time. I appreciate you.
Cheers and Aloha,