45. LO.6 Last year Christian sold a tract of land (basis of $1 million) to Kate

Question

45. LO.6 Last year Christian sold a tract of land (basis of $1 million) to Kate (an unrelated party) for $4 million, with a cash down payment of $1 million and notes for the balance. The notes carry a 7.5% rate of interest and mature annually at $1 million each over three years. (Christian did not elect out of the installment method.) Before any of the notes mature and when they have a fair market value of $2.8 million, Christian gives them to Grace. a. Disregarding the interest element, what are the Federal income tax consequences of the gift? b. Suppose that instead of making a gift, Christian dies and the notes pass to his estate. The executor sells the notes for $2.8 million. What is the Federal income tax result?

Explanation / Answer

Part A)

The maximum exclusion that can be obtained towards each gift is $14,000 as per the applicable rules of IRS. Therefore, Christian will be liable to pay gift tax on the balance amount of $2,786,000 ($2,800,000 - $14,000). Christian is, however, entitled to adjust this balance amount against the applicable life exclusion amount (as per the relevant provisions of IRS). This adjustment would reduce the liability on account of gift tax. As and when the installment is received, Christian is required to pay tax on the income generated from such notes. As a consequence, Grace will be subject to increased assessment.

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Part B)

Christian will not be subject to gift tax in this case. The total value of the notes will be treated as a part of Christian's gross estate and will be considered for estate tax. No capital gain will be realized on the disposal of the notes. As a result, any tax liability on account of income tax will not arise in the given case.

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