Inter-related Gift Transactions Between U.S.  and Foreigner; Tax-Free Exchange vs. Residence Exclusion

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, August 6, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Question:  Can a U.S. taxpayer gift stock worth $200,000 to a foreigner (a non-U.S. citizen or resident) who then sells the stock at a gain and shortly thereafter receive the stock proceeds as a gift back from the foreigner? (Note: A foreigner does not pay a capital gains tax on the stock sale, and gifts from a foreigner are generally free of gift tax).

Answer: No. There are two issues: First, you will incur a tax on the transfer because your gift exceeded $10,000. The annual gift-tax exclusion permits you to transfer a total of $10,000 ($20,000 for a married couple), in money or property, per person each calendar year. Therefore, you will either pay the tax or reduce your "applicable exemption amount" for gift and estate taxes (worth $675,000 in 2000) by $190,000 ($200,000 less the $10,000 annual gift tax exclusion).

Note: If you transfer stock when the value is low (pre IPO-stock, for instance), you maximize the number of shares that can be transferred without adverse gift-tax consequences.

Second, if the foreigner sells the stock and immediately "gifts" the profits back, IRS may claim there was no gift; instead, the IRS may assert that the foreigner acted as the taxpayer’s "agent" and the actual selling party was the taxpayer who must report the gain.

IRS and the courts look to the substance of any transaction and not just the form. Because the taxpayer transferred stock and received cash in an integrated transaction, he is considered the seller of the property, despite the intermediate step of gifting the stock to the foreigner to avoid the capital gains tax.

If the foreigner held the stock for several years, then sold it and independently decided to transfer the proceeds to the U.S. taxpayer as a gift, the transaction should survive IRS scrutiny.

The sale of stock escapes tax, but the proceeds (assume $200,000) become part of the taxpayer’s estate for estate tax purposes. The result: the U.S. taxpayer decreased his applicable exemption amount by $190,000, but failed to reduce the size of his estate because he received the proceeds from the original gift several years later. Thus, $190,000 of the applicable exemption amount has been wasted.

In conclusion, the taxpayer must compare the benefit of reducing the capital gains tax (an approximate 27.5% combined federal and state income-tax rate) with the cost of increasing his potential estate tax (generally, a maximum 55% federal estate-tax rate – California does not have an independent estate tax).

Question: We are considering purchasing a house that we have rented for the past four years. The seller ( a single person) turned 55 years old and would like to sell the rental unit without realizing a capital gain. Is this possible?

Answer: No. In general, the rules involving a once-in-a-lifetime election to exclude up to $125,000 in profits from the sale of a principal residence by taxpayers age 55 or older have been repealed.

There is now a much broader exclusion of gain upon the sale of a principal residence, regardless of the seller’s age: if the seller has owned and lived in the residence for a total of 24 months during the 60-month period prior to the sale, the exclusion is $250,000 for single filers and $500,000 for joint filers. If the seller met the exclusion requirements and rented the home to you for no more than 36 months prior to sale, he could exclude up to $250,000 in gains from taxes.

In your situation, the owner should consider using the tax-free exchange rules under tax code Section 1031, which permit the owner to acquire replacement real property with your proceeds without paying tax on the transaction. Section 1031, however, merely defers the payment of tax until the replacement property (or properties if a series of exchanges occurs) is eventually sold.

The seller must use caution to complete the exchange in accordance with Section 1031; he cannot actually or constructively receive your proceeds, then purchase another property. Usually professional guidance is needed to navigate through these rules.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.