Q. I own a two bedroom condominium apartment in Alexandria, Virginia, and my son, his wife and their two year old son are currently living there. In the near future, I would like them to become the owner of the property. I understand that I cannot give the property to my son, as it would exceed the IRS allowable limit on gifts, which I understand this year is $11,000. My condominium is worth approximately $125,000, which my son cannot afford to purchase outright.

Am I permitted to sell this apartment to my son for a very low or nominal price?

A. I would be very reluctant to sell the apartment to your son at a price which is considerably below market value. If you are audited, the IRS may take the position that the difference between the sales price and the fair market value was a gift, and you may have to pay a gift tax as a result of the transaction. Additionally, by selling the property at a low price, you may indirectly impact on the true market value of the apartment. Appraisers looking to determine the market value of other apartments in the condominium complex will see the price you have sold to your son, and will then reduce their assessment of other comparable units.

There is yet another reason why I cannot recommend a reduce sale. Currently, the tax laws permit a married couple who have lived in their house for two out of five years before sale, to exclude up to $500,000 of gain from income tax consideration (taxpayers filing individual returns can exclude up to $250,000 in gain). However, there is no guarantee that this favorable law will remain on the books forever. If Congress in the future decides to modify or scrap this law, and revert back to the older systems of calculating gain, it is important that the purchase price be as high as possible. And it is also possible that your son may not stay in the apartment for two years.

Let’s look at this example. You son buys the apartment for $50,000, and one year later sells it for $175,000. Assuming that he cannot claim that he is entitled to hardship relief – such as a change in place of employment, health or other unforeseen circumstances – he has made a gain of $125,000. Under current capital gains tax rates, he may have to pay as much as $25,000 to the IRS.

Furthermore, the IRS might frown on the transaction, and charge you with a gift tax. The IRS – and the Courts – define fair market value as being the price which a property will bring when offered for sale by a willing seller to a willing buyer, neither being obliged to buy or sell. Clearly, if you sell the property to your son for only $50,000, that does not meet the test – nor the definition – of its fair market value.

All is not lost, however, since you do have a couple of options available to you.

You can sell the property to your son, at a price close to fair market value. You certainly can deduct what you might have had to pay for a real estate commission, and you also can pick up some – or even all – of your son’s closing and settlement costs. Let’s look at this example:

The property is worth $125,000 and you have a mortgage on the property in the amount of $75,000. You can sell the property to your son for $110,000, since this represents approximately what you might have received if the apartment had been placed for sale on the open market. Your son can assume the outstanding mortgage, and you can take back a second trust in the amount of $35,000 ($110,000 - $75,000). This second trust can carry a low 5 percent interest rate, which your son will make monthly. You can even structure the second trust to be “interest only” payments, which means that he would only have to pay $145.83 per month. This obligation can become due in 5 or 7 years; this is called a “balloon note”. If the second deed of trust is recorded among the land records in the County where the property is located, your son will be able to deduct for income tax purposes the interest he pays on both the first and the second deed of trust.

Additionally, since you have the right to gift your son up to $11,000 per year, you can decide to give him back (as a gift) the interest he is paying you on a monthly basis.

Your son must keep current on your mortgage payments to the first trust lender. You should also advise your lender that you have sold the property to your son. Keep in mind that most mortgages in existence today (also called deeds of trust) have what is known as a “due on sale” clause. This means that the lender has the right to call the entire loan due if you sell the property. Lenders do not like to allow assumptions, especially if the current interest rate for mortgages happens to be higher than your existing loan.

However, as a result of a law passed by Congress in the early l980's, lenders cannot enforce the due on sale clause under certain circumstances – one of which is a sale from a parent to a child.

If you have no current mortgage, or if you are able to pay it off in full, you can also sell the property to your son and take back the entire mortgage. Either way, your son will be able to own the property – and take the tax deductions while benefitting from possible appreciation – for little or no money down.

There is one additional way that you can get ownership into your son. You indicated that the gift tax is limited to $11,000 per year. But that is a limit applicable only to one person. There is nothing stopping you from gifting $11,000 each to your son and his wife.

Let’s look at the example again. The property is worth $125,000. Seventeen percent of this equals $21,250 – which is below the yearly threshhold for a gift to two persons. You can gift – by a recorded deed – each year 17 percent of the property to your son and his wife; in less than 6 years they will own the entire property. Under this arrangement, you will have to pay no gift tax and no capital gains tax, and your family will ultimately own the entire property in – as we lawyers like to say – fee simple.

However, you should understand that the tax basis of a grantee is the basis of the grantor. Thus, when your son and his wife end up with full ownership, for tax purposes their basis will be what you initially paid the the condominium apartment. As discussed above, this may have negative tax ramifications for your son in the years to come.

This is a very common problem facing many parents today – especially when the price of homes is often way out of the price range of young couples. There are a number of options available to you but you also want to make sure that you are not affecting your own tax situation.

Discuss these issues carefully and openly with your financial, tax and legal advisors before taking any action.

Published: June 17, 2002

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Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of Kass, Mitek & Kass, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts. Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.