Gifted House vs. Inherited House: Which is Better for Taxes and Medicaid Eligibility?
When homeowners do estate planning, their most common question is how to transfer the ownership of their home to their heirs. Should you gift your house during your lifetime or leave it as an inheritance upon your death? Well, it depends. However, the answer can be straightforward once you consider your goals. This post evaluates the essential considerations that can help you determine whether gifting a house or giving it through inheritance is the better option.
Tax Implications
First, let’s take a look at the tax implications associated with a gifted vs. inherited house. While we will outline these below with examples, we are not tax professionals. Please consult with an accountant or tax professional to confirm the tax implications for your financial situation.
Gifted House
There are two important tax implications to consider when gifting a property:
Gift Tax
For a gifted house having a value that typically exceeds the annual exclusion amount (currently at $18,000 in 2024), the Internal Revenue Service (IRS) requires the current homeowner or giver to file a gift tax return (Form 709). However, the giver can apply for an exemption by taking advantage of the lifetime estate and gift tax exemption, which in 2024 is currently $13.61M per individual.
To illustrate, if you are looking to gift a home worth $500,000 to your heir, you will exceed the $18,000 annual gift exclusion limit. The amount that exceeds this limit, which in this case is $482,000, is subject to taxes. However, you can report the gift to the IRS and deduct the $482,000 from your $13.61M lifetime exemption. Thus, you can give away the $500,000 home tax-free. Furthermore, you are still eligible to give away up to $13.128M ($13.61M less $482,000) tax-free in the future.
Capital Gains Tax
When the recipient of a gifted house sells the house, the sale will be subject to capital gains tax. Capital gains tax works by considering the concepts of cost basis and carryover basis.
Cost Basis: The cost basis of a house is the purchase price plus any cost of improvements that the original owner spent on it. If you buy a house for $100,000 and have spent $50,000 on renovations and fees, the cost basis would be $150,000.
Carryover Basis: Upon gifting a house, the receiver inherits the original owner’s cost basis, i.e., the cost basis “carries over” to the gift receiver. When the receiver sells this gifted house, the difference between the selling price and this carryover basis will be subject to capital gains tax.
For example, your house, which has a cost basis of $150,000, was gifted to your heir when its market value was at $300,000. If your heir later sold this gifted house for $500,000, the capital gains subject to tax will be $350,000 ($500,000 less $150,000), not $200,000 ($500,000 less $300,000). Thus, the higher the home value appreciates, the higher the capital gains tax your receiver will pay upon the sale of your gifted house.
Inherited House
Similarly, there are also two tax implications to consider when leaving a home as an inheritance:
Estate Tax
When you leave your home as an inheritance, you essentially include it as part of your estate to be given to your heir upon your death. As such, your entire estate will be subject to estate tax. However, with the currently high estate tax exemption ($13.61M in 2024), most estates are exempted from paying federal estate taxes. Some US states, however, may have their own estate or inheritance tax thresholds, so even federal tax-exempt estates may be subject to state taxes. Our service areas of Arizona and California do not have state taxes for estates.
Capital Gains Tax
When your heir sells their inherited home, capital gains tax calculations will consider the step-up basis. This means that the cost basis is “stepped up” to the fair market value (FMV) at the time of your death. The capital gains tax will be calculated by considering the property’s market value at the time it was inherited, not the time it was purchased.
To illustrate, your house, with a cost basis of $150,000, was valued at $300,000 upon your death. The basis thus steps up to $300,000. If your heir later sells the house for $500,000, the taxable capital gains will be $200,000 ($500,000 less $300,000). Thus, the step-up basis can minimize the capital gains tax that the heir would pay if they sell an inherited property.
Furthermore, if your heir owns and uses the inherited house as a primary residence for at least 2 years in the 5 years before selling it, they can file for primary residence exclusion. This can exclude up to $250,000 ($500,000 if the heir is married and filing jointly) of the capital gains from taxes.
Medicaid Eligibility Implications
Many people focus on the tax implications of their estate planning, but in doing so, they overlook how their decisions may impact their Medicaid eligibility. Below is a comparison between gifted and inherited houses in terms of Medicaid eligibility:
Gifted House
Gifting a house can considerably impact your Medicaid eligibility. Medicaid has a five-year look-back period for gifts and transfers of assets. If you gift a house within five years before applying for Medicaid, it can result in a penalty period in which you are ineligible for Medicaid benefits. This penalty period varies on the value of the gift and the average monthly cost of care. For example, if you gifted a house valued at $500,000 and the average monthly cost of care is $50,000, you will be ineligible for Medicaid for 10 months.
Medicaid can allow gifting your home within the look-back period only under the following conditions:
If the receiver is your spouse.
If the receiver is your child who is under 21 years old.
If the receiver is your child who is blind or disabled.
If the receiver is your sibling, who is a part owner of the home and has lived in it during the year before you transfer to the Medicaid facility.
If the receiver is a “caretaker child” or your child who has lived with you for at least two years and provided care before your transfer to the Medicaid facility.
If the homeownership is transferred to a trust that benefits your child who is blind or permanently disabled.
If the homeownership is transferred to a trust that benefits anyone under 65 who is permanently disabled.
By gifting your house outside the Medicaid look-back period, you can preserve the asset for your heirs without affecting your future Medicaid eligibility. Also, if the house is gifted before the look-back period, it is not subject to Medicaid estate recovery, which means Medicaid cannot claim the house to recover costs after your death.
Inherited House
A primary residence is considered an exempt asset in terms of Medicaid eligibility. This means that you can keep your home as part of your estate, i.e., you don’t have to sell it to qualify for Medicaid as long as:
You or your spouse live in the home.
You have the intent to return home if you are in a Medicaid facility.
A dependent child or relative lives in the home.
Medicaid may impose equity limits to exempt your home as a primary residence. If your home’s equity (i.e., its current worth minus what you owe in mortgage) is above this limit, you may incur a penalty period of ineligibility.
If you avail of Medicaid while living and your house is part of your estate upon death, your house may be subject to Medicaid estate recovery. The state may place a lien on the house or claim a portion of the proceeds from its sale to recover the amount Medicaid paid for your care. Your house will be protected from this process if it goes to the following heirs:
Your surviving spouse
Your minor or disabled child
Your siblings, provided they have lived at least one year in the home
Your adult children caregivers, provided they live in the home and have cared for you for at least two years
Gifted House vs. Inherited House: Which is Better?
For tax purposes, leaving a house as an inheritance generally has more tax advantages for both the giver and receiver. Exemptions on estate taxes are easier to avail of, and the potential capital gains tax is minimal due to the step-up in basis. Gifting a home can be preferable in terms of tax if you can avail of gift tax exemptions and if your heir sells your home shortly upon receiving it to minimize capital gains tax.
For Medicaid eligibility, gifting a house is a better option if you do it before the look-back period. This eliminates the danger of a penalty period and estate recovery upon your death. On the other hand, with the right estate planning tools that will protect your assets upon your death, leaving your house as an inheritance becomes similarly beneficial.
Each person’s situation is unique, and the best way to transfer homeownership depends on the specific circumstances of the giver and receiver. On top of the above considerations, don’t forget to factor in your current financial situation, health, and estate planning goals. Consulting with a legal advisor or estate planning attorney can help tailor your home-giving decisions to your needs. Call to schedule your free consultation with Rilus Law experts today!