Children concerned about tax implications after selling gifted home and returning money to parents

Here’s our question: Do we, their children, owe tax on the gain? A tax preparer we spoke to said “No,” because our parents had constructive control over the house and no 1099-S was issued.

A: This is a lot to unpack, and it goes to the heart of why it’s almost never a good idea to gift a home to your children rather than letting them inherit it after your death.

Let’s start with the fact that at sometime in the past, your parents gave their home to you and your siblings. When your parents gave the home to all of their children, we suspect they still treated the home as theirs although they knew that the kids now owned it.

Fast-forward several years and your parents need money. So, you and your siblings sell the home and give your parents all of the cash (we assume) from the sale. How was the property treated on all of your tax returns and how was the home?

First, when your parents gave you the home, did they fill out a deed with your names on it? Did they have the deed filled out, signed, properly notarized and completed as required by local law? Was the deed filed or recorded with the office that handles the filing or recording of real estate documents? These would all be signs that the home belonged to you and your siblings and not your parents. (We’ve previously explained how you can check the status of your deed by going to your local recorder of deeds website.)

Did your parents take a deduction for any real estate taxes they paid on the home after selling it to you? Once the home was no longer theirs, they wouldn’t have been typically entitled to take that federal income tax deduction.

We doubt that you and your siblings ever treated the home as a rental property. We’re guessing that you didn’t receive rent or income from your parents or claim any of the preferential tax treatment available to real estate investors. On the other hand, we assume you and your siblings probably didn’t pay the real estate taxes, insurance, upkeep, maintenance, repairs or improvements for the home while your parents lived there.

Let’s talk about profit: How much did the home sell for? Was there any net profit (after the expenses of purchasing and selling it)? How long did you and your siblings own it before selling it?

If your parents owned the property and lived there as their primary residence for at least two of the last five years, they’d be entitled to keep up to $500,000 in net profits (up to $250,000 per person) tax from the sale. (We have also explained how to calculate your home’s cost basis.) We don’t think your parents were entitled to use the home sale exclusion because, according to you, they didn’t actually own the home when it was sold.

The deed that transferred ownership of the home to the new buyers would have been signed by you and your siblings as you were the owners of the home from the time your parents gave you the home.

When you sold the home, you and your siblings (as the owners) would normally owe any federal or state taxes due on the sale of the home.

Your accountant has a different take. You say that your accountant told you that your parents would have the obligation to pay those taxes. The accountant’s argument is that your parents — for all practical purposes — owned the home except they didn’t have their name on the title to the home. He said that your parents constructively owned the home and you can ignore who actually owned the home.

That’s an interesting argument. We’d need to know more about your situation before deciding whether to concur with your accountant: Did your parents always refer to the home as being owned by their kids? Did you and your siblings understand that the home was yours and not your parents’ home? Did your parents have you and your siblings pay for some of the expenses of the home or take care of matters relating to the home? Did all of you truly believe your parents no longer owned the home? If these statements are true, we wonder how you can now go to the IRS and say that your parents constructively owned the home.

Your parents must have had a reason to put the title of the home in the name of you and your siblings. Sometimes parents make this transfer to avoid probate issues when they die. Other times, parents put the home in their kids name to avoid having assets when they apply for medical assistance or Medicaid down the line. Sometimes they transfer assets if they’re being chased by a creditor and may go into bankruptcy. All of these factors may play into whether your parents constructively owned the home or whether you and your siblings owned it.

Our advice to you is to determine whether there is any tax owed on the sale of the home. If not, then it might not make a difference who owned the home at the time of sale. If there is a large profit on the sale of the home, we’d suggest you sit down with a tax attorney or enrolled agent to go through all of the facts in your situation and confirm whether your parents constructively owned the home, or not.

(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, a financial wellness technology company. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.)