The views expressed are those of Anchor Capital Advisors, LLC (“Anchor”) and are subject to change at any time. They are based on our proprietary research and general knowledge of said topic. The below content and applicable data are in support of our views on said topic. Please see additional disclosures at the end of this publication.
INTRODUCTION
Owning real estate provides many benefits, whether it is personal enjoyment, rental income, or an increase in value. One benefit easily overlooked is the tax benefit from years (or decades) of price appreciation. You don’t have to pay income taxes on the increase in value of your property unless you decide to sell it. For long-term owners of real estate, even modest inflation and appreciation can lead to significant gains in the year of sale—that is the power of compounding returns.
These benefits, however, may not go on forever. When you sell your property, those years of gains will all be taxed in the year of sale as capital gains. But what if you never sell the property? What if you gift it? An important part of any comprehensive financial plan is analyzing and managing your tax exposure. Each client is different, and there are many issues to consider when deciding how to manage your real estate.
The primary considerations are generally your long-term goals and needs. Taxes are a concern, but they shouldn’t be the primary driver of any financial decision. Only after you identify your goals can we determine the most efficient means to obtain them. An advisor should balance the income tax, estate tax, and gift tax implications of a sale or transfer. It is easy to focus on just one level of tax, but these issues are often interrelated, and tax savings in one area can come with competing tax costs in others.
Below is a summary of basic income tax, gift tax, and estate tax consequences of a sale, a lifetime gift, and inheritance (a gift upon death). The summary highlights some income tax issues for specific types of property, such as primary residences and rental properties. Once those issues are developed, this paper summarizes several common strategies designed to minimize the tax impact of gifts and inheritances.
ESTATE AND GIFT TAXES [1]
At the federal level, estate and gift taxes are imposed on transfers of property during your life (gift tax) and at death (estate tax). There are two exemptions to be aware of:
- Annual exclusion gift: this is the amount you can give to a person before you are required to file a gift tax return. Importantly, exemption applies per each recipient, not on the giver’s cumulative gifts. In 2025, the annual exclusion was $19,000, so you could gift $19,000 to as many people as you want without having to file a gift tax return.
- Lifetime Exemption: this is the amount you can gift, over and above any annual exclusion gifts, during your life or at death, before you incur any estate or gift taxes. In 2025, the lifetime exemption is $13,990,000 per person ($27,980,000 for married couples, combined).
You are only liable for the estate or gift tax if you exceed the lifetime exemption. Trying to avoid or limit your exposure may make lifetime gifting more attractive. While the federal exemption is historically high, most people may believe there is nothing to worry about. However, each state has their own rules: many states do not have an estate or gift tax, some have an estate tax but no gift tax, and some have both. Moreover, each state has different thresholds for when the estate tax applies, but generally the exemptions are much lower than the current federal exemption. As a result, estate and gift tax planning may be very important at the state level.
PROPERTY TRANSFERS
OUTRIGHT SALE
When you sell property, you generally pay tax on the difference between the sales proceeds and your cost basis. Your cost basis includes your purchase price plus the cost any improvements or additions to the property. The gains would be taxable as capital gains, could be eligible for preferential rates if the property was held for longer than 12 months (long-term capital gain), and could be offset by capital losses. If the property was used personally (not for rental or business use) and is sold at a loss, there is no capital loss allowed on your tax return.
Taxpayers selling their “principal residence” [2] can exclude up to $250,000 of gains ($500,000 for married couples filing jointly). To qualify for this exclusion, you must satisfy several tests. The most important of these are the “use” test and the “time” test. Under the “use” test, you must have used the property as your “principal residence,” so a second home, vacation home, or a periodic residence would not qualify for the exclusion. Under the time test, you must have used the property for at least 2 years during the 5-year period immediately preceding the sale. This can be very powerful for long-term homeowners.
OUTRIGHT GIFT
An outright gift of property is possibly the simplest and cheapest way for an owner to transfer property to their beneficiaries. While we are discussing real estate, the same concept for gifting applies to any asset. It is the cleanest in terms of clarifying legal ownership and for tax reporting purposes. A lifetime gift may be more attractive to some people because it allows them to lock in the value of the gift at the time it is made, so any future appreciation is outside of their estate. It also allows the donor to see their beneficiaries enjoy the gift while they are alive.
A gift can be made directly or through an entity, such as a trust. The tax implications are the same. However, choosing an entity like a trust can have other benefits, such as clearly establishing the rights and obligations of the beneficiaries, providing a method for dispute resolution, and offering creditor protection for the beneficiaries. Of course, ownership by an entity can create some administrative burdens, too. The important thing to remember is that you will have flexibility.
For income tax purposes, there will be no reportable transaction. The only income tax implication is the beneficiaries receive a “carryover” cost basis [3], meaning they will have the same cost basis as the people who transferred the property. If the fair market value of the property is greater than the cost basis when the gift is made, the beneficiaries inherit a potential tax liability. However, that only matters if they sell the property. We can compare this to a “step-up” in basis for inherited property, discussed later.
One tax item that does not carry over from a gift is the holding period for the gain exclusion on the sale of a principal residence, discussed above. The clock for this exclusion restarts only when the new owners begin using the property as their principal residence.
For gift tax purposes, the original owners would report the value of the property on the date of the gift on a gift tax return. If the value exceeds the annual exclusion ($19,000 per person in 2025), that amount will be considered a gift and will reduce their lifetime exemption. Even though the gift may exceed the annual exclusion, that does not mean there will be a tax liability. Exceeding the annual exclusion only triggers a reporting requirement, and no tax will be due until you exceed your lifetime gifting limit.
INHERITANCE
Some people may not want to—or may not be able to afford to— gift property during their lifetime. Instead, they are happy to leave the property as an inheritance, a gift made on the donor’s death. The estate tax consequences are generally the same as the gift tax consequences; the only real difference is the beneficiary receives the property later and, likely, at a different valuation.
The real difference between receiving an inheritance and a gift during the donor’s life is the beneficiary’s cost basis after receiving the property. Instead of a carryover cost basis, the beneficiary of inherited property receives a full “step up” in cost basis [4], which means they are treated as having purchased the property for FMV on the date of the donor’s death. Any gain in the property accrued during the donor’s life goes away. The beneficiary can turn around and sell the property at little to no gain (there may still be some fluctuation in value between the date of inheritance and the sale).
SPECIAL CONSIDERATIONS FOR RENTAL PROPERTY [5]
Rental properties share most of the same considerations as personal use property. However, there is another tax issue that can impact your decision to sell or gift a rental property: depreciation recapture.
When you begin renting property, you are allowed to start deducting a portion of your purchase price. This is called depreciation, and this deduction can offset some or all your rental income. However, if you sell your rental property, you must “recapture” all the depreciation taken by reducing your cost basis by the amount of depreciation claimed.
If you gift a rental property, the beneficiary will inherit the depreciation along with the carryover cost basis. Therefore, if they sell the property, they too will be taxed on the depreciation recapture. If the original owner holds the property until death, however, the beneficiary receives a step up in basis and the depreciation recapture is eliminated. Not only that, if the beneficiary wants to continue to rent the property, they can now restart the depreciation using the higher cost basis.
SECTION 1031 TAX DEFERRED EXCHANGE [6]
Another option for owners of business or rental property is a 1031 exchange. The types of exchanges are usually referred to as a “like kind” exchange or “tax-deferred” exchange. The 1031 refers to the section of the tax code that allows owners of business or investment property to exchange their property for other business or investment property without paying tax on the gain at the time of the exchange. Rather, the owner would simply transfer the cost basis of the old property to the new property.
The primary benefit of a 1031 is that it allows you to essentially sell one property and buy another property without having to pay tax on the sale. There are several formalities that must be obeyed to qualify for the like kind exchange, however—you can’t literally sell a property and use the cash proceeds to buy another and claim no tax due on the gain. The person looking to benefit from a 1031 exchange cannot receive the cash proceeds directly. Instead, you usually need to use a third party, such as a “qualified intermediary” to facilitate the exchange and hold the sales proceeds in escrow. After you sell the property, you must then identify potential replacement properties within 45 days and you must close on the purchase within 180 days of the initial sale.
This transaction does not directly help a property owner transfer property in a tax-efficient way to their beneficiaries. However, a 1031 exchange could be beneficial with an intent to gift the property during the owner’s life or at death. For example, what if the beneficiary does not want to own a certain type of real estate or does not want to own real estate in a certain location (perhaps they live on the other side of the country). Or, perhaps you have several beneficiaries that stand to inherit a single property, and you (or the beneficiaries) would rather they all inherit separate properties so they wouldn’t have to worry about co-management. A 1031 exchange could help the owner of the property exchange the less desirable property (in the eyes of the beneficiary) for a more desirable property (or properties).
Another benefit of a 1031 exchange is that you can identify properties that may be ideal for personal use later. A 1031 exchange requires you to exchange qualified property, property you intend to hold as business or investment property, for other qualified property. However, there is no requirement that you must hold that property for that purpose forever. Your plans may change, and you or your beneficiaries may decide to use the new property for personal use. So, you could identify a new property that could be used as a vacation home in the future without sacrificing the benefits of a 1031 exchange.
GIFTING STRATEGIES
As you can see, there are key differences between lifetime gifts and inheritances for both income tax purposes and estate and gift tax purposes. What makes sense for you depends on several factors, including the long-term goals for the property, the potential estate tax liability, and the cost basis in the property you are considering gifting.
Below are three strategies that can benefit people who determine lifetime gifts are most appropriate.
1 – GIFT SALE [7]
A gift sale—or discount sale—is when the owner of property sells their property for less than fair market value. The purpose of this type of sale is to provide some benefit to the purchaser of the property while allowing the owner to still monetize some of the value. This can be useful for an owner that either wants their beneficiary to have “skin in the game” by way of
paying something for the property, or for an owner that wants to provide a gift but still needs some of the proceeds to help fund their long-term financial goals, just to name a few.
For income tax purposes, the seller would report the amount received— not the fair market value of the property— as their gross proceeds for calculating gain or loss on the property. The lower gross proceeds help limit the income tax consequences of a sale, as compared to selling the property for its full fair market value. For the purchaser, their cost basis moving forward would be their purchase price.
For estate and gift tax purposes, the seller of the property is making a gift of the difference between the fair market value of the property and the sales price. The difference is treated as a gift and reported on their gift tax return. For the purchaser, the gifted amount would not receive a step up in basis or any carryover basis; rather, their cost basis in the property would
be their purchase price.
2 – LIFE ESTATE [8]
A life estate is a transfer where the current owner of a property transfers the deed to their home to their chosen beneficiary but retains the right to live in the home for the rest of their life. This essentially creates two separate interests in the property: the lifetime interest of the original owner(s) to live in the property and the remainder interest of the
beneficiary to use or sell the property upon the death of the owners of the lifetime interest.
The benefits of the life estate are several, including:
- The transfer to the beneficiary on the original owner’s death will avoid probate. It will start the clock on the Medicaid “look back” period for benefits.
- The beneficiary will receive a step up in cost basis on the death of the original owner because the full value of the property is included in the original owner’s estate for estate tax purposes.
- A life estate deed is usually cheaper than creating a trust or other structure.
There are downsides, however, including:
- The owner loses sole control of the property and cannot sell or mortgage the property without permission from the beneficiary.
- The property is included in the owner’s taxable estate. While this provides the beneficiary with a step up in cost basis, you must also consider the estate tax consequences.
- The beneficiary’s remainder interest could be subject to their own liabilities at the end of the life estate: divorce, death, creditors, or just general disagreement with other beneficiaries over the management or use of the property.
3 – QUALIFIED PERSONAL RESIDENCE TRUST (QPRT) [9]
A qualified personal residence trust is an irrevocable trust designed to minimize estate and gift taxes by moving personal real estate to a trust. What distinguishes a QPRT is:
- The grantor retains the right to live in the home for a specific number of years before the property is distributed to beneficiaries.
- The grantor can claim a discount on the value of the property on their gift tax. The amount of discount depends on the duration of the retained right to use the property and the interest rate in effect at the time of the transfer (Section 7520 interest rate).
Once the trust term ends, the property is distributed to the trust beneficiaries. There is no additional estate or gift tax consequences, even if there is significant appreciation in the asset—in fact, that is largely the point of a QPRT. There are three key considerations when deciding to create and fund a QPRT:
- The grantor no longer owns the house. The beneficiaries are the legal owners at the end of the QPRT term and have no obligation to let the grantor use or rent the property. However, the original owner can always rent the property at fair market value after the QPRT term.
- The beneficiaries will not receive a stepped-up cost basis in the property. Because a transfer to a QPRT is a lifetime gift, the beneficiaries will inherit the grantor’s cost basis.
- The grantor must outlive the term of the QPRT to get the full gift tax benefits of a QPRT. If the grantor dies before the term ends, the property is included in the value of the grantor’s estate.
Based on these factors, a QPRT is best for taxpayers who:
- Are concerned about estate taxes if the full value of the property is included in their estate.
- Do not expect the beneficiaries to sell the property in the foreseeable future.
- Because there is no step up in cost basis, a QPRT is usually best for taxpayers that have a large potential estate tax liability that offsets the benefits of forgoing a step-up in cost basis for income tax purposes.
NEXT STEPS
As you can see, there are many ways a property owner can transfer property to their beneficiaries. We discussed a few common strategies and the tax impacts of each. However, before you decide how to make a transfer, it is important to review your entire financial situation with your advisor. The decision can have significant financial implications, so you should first clearly define your goals and understand the tax implications of any potential transaction.
[1] Federal estate and gift exclusions: https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025 ; https://www.kiplinger.com/taxes/whats-the-new-estate-tax-exemption; State level estate, gift, and inheritance taxes:https://taxfoundation.org/data/all/state/estate-inheritance-taxes/
[2] Section 121 principal residence gain exclusion: https://www.taxnotes.com/research/federal/usc26/121
[3] Carryover cost basis: https://www.taxnotes.com/research/federal/usc26/1015
[4] Step up in cost basis: https://www.taxnotes.com/research/federal/usc26/1014
[5] Depreciation and depreciation recapture: IRS publication 527, specifically Chapter 2: https://www.irs.gov/pub/irs-pdf/p527.pdf; IRS publication 946 (chapter 4): https://www.irs.gov/pub/irs-pdf/p946.pdf
[6] Section 1031 Like Kind exchange: https://www.taxnotes.com/research/federal/usc26/1031
[7] Gift sale: https://www.taxnotes.com/research/federal/cfr26/1.1015-4
[8] Life estate: https://smartasset.com/estate-planning/life-estate
[9] QPRTS: https://www.taxnotes.com/research/federal/usc26/2702; https://rsmus.com/insights/tax-alerts/2024/estate-planning-qa-qualifiedpersonal-residence-trusts-explained.html
The views expressed are those of Anchor Capital Advisors, LLC (”Anchor”) as of the date written and are subject to change at any time. Anchor does not undertake any obligation to update the information contained herein as of any future date, nor does it have liability for decisions based on this information. Certain information (including any forward looking statements and economic and market information) has been obtained from sources we deem reliable, but is not guaranteed by Anchor, nor is it a complete summary of available data. This publication has been prepared by Anchor Capital Advisors, LLC (Anchor). The information is for educational purposes only and should not be considered investment advice or a recommendation of any particular strategy or investment product. These opinions are not intended to be a forecast of future events or a guarantee of future results. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of Anchor. Past performance is not guarantee of future results. Inherent in any investment is the possibility of loss.