Deduction for Forgiven Interest

I sell to my daughter and forgive $13000 interest each year. I have to claim that interest as income, no? As long as I have a legit loan to her, paper in place, and lien on the property, the deal looks right, she gets deduction, he pays tax on interest.

What's missing is that if he dies, there's a step up in basis. On this sale, that appears to be lost.

My understanding is that if your daughter claims it as cancellation of debt income, you don't have to claim it. But then she gets an interest deduction to offset the income.

Yes, but the basis will be increased to the current market value on the date of the sale, which is a help. The estate will have a note that will probably have a value of less than the real estate it helped purchase.

___ Stu

Agreed, but the seller will have a cap gain (or is he covered by the $250/$500?). If the exclusion covers most of the gain, the strategy is decent. I cite the above lest someone do this with a very old house now worth a lot of money where there's a gain for the seller that's huge. For you guy, this plan may be perfect.

The property wasn't his residence, so it doesn't qualify for the exclusion. And with depreciation recapture he'll probably be paying full rates on most if not all income. But since he's paying tax on all the rents received anyway, and the net received will be roughly the same, it shouldn't make a difference to him on that score.

___ Stu

I'd look at the numbers very carefully. Doing the math to see his tax bill for this "sale" vs the amount he's potentially saving in his estate by selling this asset at the current value. There's a tradeoff in this deal, as he's still giving up the non-taxed step-up on his death. Does he have the liquid funds to pay the tax bill? Depending on the numbers, and the estate exclusion when he passes, it may work in his favor or not. Just bringing up the issues that I see need analyzing.

Those are excellent points, and probably the reason I have never suggested this kind of thing for a client before. But this guy's estate is well over $1 million, and paying income tax on any dollar is going to be better than paying estate tax on it.

___ Stu

Wait... what? I am probably missing many of the nuances here, but this caught my attention. How does a gift (as implied by the $13K limit) suddenly transform into cancellation of debt?

Ok. In 2012, the lifetime gift exclusion is $5.12M. From what you suggest above, the client fears having it drop to $1M, and having his estate subject to 55% tax. Why not counsel him to gift some or all of the property this year?

If his goal is tax avoidance (the legal good planning) then I'd first consider how to start the process with no tax bill right now.

The sale of say $1M property to his daughter gets the physical building out of his estate, but trades it for a note plus downpayment that add up to the same $1M. The shift in title gets future gains out of the estate but at what may be a high immediate cost. Not knowing all the details, I'm just thinking out loud. He can gift a fractional ownership for whatever share he wishes. If a building is owned by a minority owner who has the right to not sell out, the value is reduced quite a bit for the estate tax. I don't know more than that about this than what I mentioned, but I've read there are many ways to reduce asset value in the year prior to death to help pass more wealth tax-free.

after the end of this year, any given made this year in excess of the lifetime exemption in the year of death will have to be drawn back into his taxable estate.

He's already paying income tax on the income from the building. I'm thinking of how to transfer as much as possible to his kids with the income tax staying about the same as it is.

If there's a note for 30 years at 2.68% interest (I don't think the regulations require the note be secured), it will have a FMV less than the property, it seems to me.

For maximum savings he would have had to start quite some time ago. It's a little too late for a family limited partnership to have much of an effect, it seems to me.

Thanks again for your input. I appreciate it.

___ Stu

When someone owes you money and you forgive the interest, either you pay tax on imputed interest or the debtor pays tax on cancellation of debt income. At least that's the way I understand it. Interest on small loans (up to principal of $10,000 as I recall) can be ignored. But not larger loans.

I'm sure I've gotten some of the details wrong, but that's my understanding.

___ Stu

I bookmarked one article on this issue -

course, it's just one man's interpretation.Your other responses are all well reasoned, Stu. The tax code really is a mess to deal with. I'd like to see some long term commitments, and fewer patches and short term extensions. Don't forget, if the daughter is married, that's $26K/yr total to gift. Interesting situation.

There is no cancellation of debt income for the interest as it meets one of the exceptions. Specifically, the interest would have been deductible on Schedule E if paid. As such, there is no income to the daughter and there is no tax deduction for the daughter. However, I believe that the cost basis of the property has to be adjusted for the forgiveness. See the instructions for Form 982.

Additionally, no one seems to have mentioned that this is an installment sale. The father either declares the profit on the sale annually or elect to take all the profit in the year of sale.

why not gift the building subject to a retained note? No capital gains, he keeps the income stream from the note as you wish.

Selling the property on an installment sale is exactly what I'm talking about.

But your suggestion really misses a lot of issues, and could cause a lot of problems. Payments on a note would consist of interest, capital gain and return of principal. Some of the capital gain would be subject to depreciation recapture.

Then there is the issue of whether the gift portion should consist of interest or principal, and whether to make a large gift now or to do it a bit at a time, or a combination of the two.

___ Stu

That is not what I am talking about. I was talking about giving the property as a gift, but retaining a note on the property.

no, not if it is not an installment sale.

except that he pays income tax, and has a lot of money left in his estate to pay estate tax on. Kind of a double whammy.

Let me clarify what I meant. What if he establishes a note on the property first, and then gifts the property subject to the existing note? Then, payments on the note would not be part of any sale, no capital gain, etc. Just thinking out loud.

Or gift 50% of the property to the daughter, and she buys the remaining 50% for such a note. You could jigger the amount which is a gift, and the amount which is cap gain, etc. as you wish.

interesting scenario.

The idea is that he pays the same income tax he would have paid anyway, and gets at least some of the property out of his estate. Unfortunately it would have been easier and better if he'd started years ago. But he doesn't have the time now he used to.

___ Stu

Of course it's an installment sale. Retaining a note makes it an installment sale by definition.

So he should borrow money secured by the property? Who does he borrow it from? And what in the world would he do with the money he borrows? I don't see how that makes any sense.

If he got the cash from the loan you seem to be suggesting, he still has the same basis in the property. His kid would get his basis rather than current market value basis. That would result in more income tax when the kid sells the house.

In addition, the cash he got from the "note" you suggest is cash that will be taxed in his estate when he dies.

If you are suggesting he just create a note in the abstract, not borrow money but just do it to make it seem as if he did, the whole thing is a fraud and the IRS will ignore it.

___ Stu