Purchasing A Friend's Property at below appraised / market value

[justalayman]

So,the seller is gifting you $450,000 (the equity in the property)

Your contrived number of $80,000 is meaningless and unnecessary. He is gifting you $450,000 because that is the amount of value he holds that you are not paying him for.

I’m not understanding why the lender is requiring any cash from you at all. In sales requiring a down payment, the presumption is the purchase is at market value. That way there is not a negative equity from the onset. With your situation, you’ll have well over $400,000 equity the moment you close. In fact, in situations like this, it isn’t unusual for a buyer to actually pull cash from the sale to use for other purposes. Of course it increases the loan amount resulting in higher payments.


I can’t help you with the tax implications though.

 

[Taxing Matters]

Hi - the loan that is left on the house is 300K that I will need to take over. For me to make a purchase at that price, the lender suggested to use the equity of 80K so the sell price would be 380K. 300K for the loan and 80K for the gift equity. At that point, I would be only responsible for 300K loan amount to pay off. I was wondering about how the tax works for the seller and the buyer.

1. Is it ok to sell all below market value? The lender said it was ok.

It is ok sell below market value as long as the seller is not doing this to defeat some creditor that he has. Given how much equity — $450k — he is giving you, one wonders if there is something more going on here than you are telling us.

The lender's suggestion of saying that the real purchase price is $380k is odd and really unnecessary. That suggests that the person to whom you spoke (and perhaps that lender itself) still needs in form to have a 20% down payment in the deal to satisfy their requirements. That puts form over substance, something that a lender ought not do. It's sort of thinking that helped get lenders into trouble in the run up to the 2008 real estate crash.

2. The lender wasn't sure about how the tax worked. So was wondering if the seller gets taxed at 380K or 80K gift equity if any? What about the buyer?

The tax law does look at the substance, not the form. Given your updated facts, this is clearly a gift-sale sale transaction. There is no way to cast this one as a true arm's length bargained for exchange. The only thing you are paying is the $300k loan, and you are doing that by assuming or refinancing for that amount. Thus, for tax purposes, the purchase price for the property is $300k. As the house has a FMV of $750k, that makes a gift from him to you of $450k. Thus, this is a part gift, part sale transaction,

So, let's start with gift tax for the seller. The seller is making a gift to you of $450k ($750k value of the property less the $300k you are paying for it). He must file a federal gift tax return, Form 709, and report that gift. He is allowed to give you $15,000 in gifts each year without any gift tax consequence, so the taxable gift here is $450,000 - $15,000 = $435,000. He will reduce his unified credit against federal gift and estate tax by $435,000, assuming he has at least that much credit left to use up. What that means is that he will now have less that he can give in gifts during his lifetime or that his estate can give away without having to pay actual gift or estate tax. Whether that is a concern for him depends on how much he thinks he will give away during the rest of his life and how large he thinks his estate will be at his death.

Now for the income tax part of this. You have to bifurcate the deal into transactions for tax purposes, a gift transaction and the sale transaction. The gift, as mentioned above, is $450,000. He apparently has a starting basis in the property of $400,000, which was his purchase price. His adjusted basis will be different since he apparently has been renting the property to you for the last 10 years, and he has depreciation he must take into account which will lower his basis. Any improvements (e.g. additions, etc) he made to the home will increase the basis. I don't know what his actual basis today is, but he and you need to know that to properly figure the tax consequences. I'll just assume a basis of $325,000 for illustration purposes, as it makes the math easy to follow. You will, of course, need to use the actual numbers to get this right.

Under income tax law, when a gift is made of property with a gain in it the donee (you) gets the same basis in the property that the donor (seller) had in it. So we have to determine what part of his basis in the property is for the gift. Well, the gift is $450,000 and the FMV of the property is $750,000, which means that $450,000/$750,000 = 60% of the property value is going for the gift, so we allocate 60% of the basis to the gift, too. Thus, $325,000 basis x 60% = $195,000 of gift basis.

That leaves $325,000 total basis - 195,000 gift basis = $130,000 sale basis. So for the sale, the seller is getting $300,00 from you assuming/refinaancing the loan, and his basis for the sale transaction is $130,000. So he will have a capital gain for federal and California income tax of $170,0000. It's a long term capital gain, taxable at a maximum rate of 20% for federal tax, though he may have some part of that as ordinary income because of depreciation recapture. He may also have a federal net investment tax on the transaction of 3.8% depending on the other details of his income for the year. I don't know the California tax rates that will apply. Bottom line, though, is that he will have some significant income tax to pay from this.

For you, you get a basis in the sale part of the deal of what you paid for the property, $300k. Thus, your total basis in the property would be the $195,000 gift basis + the $300,000 sale basis for a total basis of $495,000. All the way around, it's a great deal for you. You are getting the property for less than half of what it is worth, you don't pay any gift or income tax on the purchase, and you get a basis more than what you are paying for it. The tax consequences for your friend are not so great. He is very generous indeed to sell it to you so cheap, not get any cash out of the deal, and to be willing to cough up his own cash to pay all the tax from this.

Note that there may be some kind of real estate transfer tax to pay here and that the transfer may result in a reassessment of the property tax value, which would increase the amount of property tax you pay going forward.

I'd strongly recommend you both get a good tax professional to help guide you through all this to get it right.