The donation of real estate held as private assets is a popular way of transferring wealth to the next generation and is common practice in Germany.
The transfer can take several forms: real estate can, for example, be transferred directly to children and grandchildren or transferred to an asset-managing partnership in which the descendants hold shares or will hold shares through a subsequent transfer of shares. When real estate assets are gifted, inheritance tax consequences are obvious if the value of the gift exceeds the respective inheritance tax allowance (EUR 400,000 for children, EUR 200,000 for grandchildren). However, when donating externally financed, rented real estate, there may also be income tax consequences of which the donor is often unaware.
No deduction of debt interest in the case of gratuitous transfer of externally financed real estate
If the donor transfers a co-ownership share in his rented property free of charge to his descendant and retains the loan used to finance the property in full, the debt interest attributable to the transferred co-ownership share is not to be taken into account as (special) income-related expenses. This means that the donor can no longer deduct the full amount of the debt interest incurred for external financing from the income from renting and leasing, but only the amount corresponding to his own share in the property.
Would you like to receive such news directly to your mailbox every two months? Subscribe to our newsletter Private Clients Update – Assets | Foundations | Succession.
The German Federal Fiscal Court (BFH) has confirmed this view in two recent decisions (BFH v. 3.12.2024- IX R 2/24 and IX R 3/24). The BFH is of the opinion that the objective connection between the debt and the generation of income ceases to exist with the transfer to the descendant free of charge. In general, in the case of the externally financed acquisition of a source of income (rented property), there is a causal connection between the loan taken out for financing and the resulting debt interest and the generation of income from renting and leasing. Even if the recipient of the gift receives a proportionate share of the income from renting and leasing, this causal connection is broken by the gratuitous transfer and the financed object is put to another use, namely the financing of the gift.
How can the refusal to deduct debt interest be prevented?
One possible solution could be to transfer the co-ownership share in the property to the descendant in return for payment. The BFH confirms that a debt interest deduction would be possible in the event of a sale of the financed property in return for payment. In such a case, there would be a realization of the source of income, which can typically also be attributed to the generation of income. According to established case law of the Federal Fiscal Court (BFH v. 20.6.2012 – IX R 67/12, BStBl. II 2013 275), the original causal connection for generating income remains even if the proceeds from the sale are not sufficient to repay the loan in full. Therefore, a (possibly proportional) assumption of the liabilities by the recipient of the gift could ensure that the recipient is also burdened with the costs as the person generating the income from renting and leasing. However, the assumption of the financing results in the recipient of the gift acquiring the property for consideration or partial consideration. It is important to note that the ten-year retention period for properties held as private assets (Section 23 EStG) must already have expired so that the sale itself is not taxable as a private sale. Alternatively, consideration could be given to reserving a usufruct for the donor – at least for the duration of the external financing – so that income-related expenses can be deducted from rental and leasing income (Section 21 EStG).
Similar problem: Externally financed real estate in an asset-managing partnership
Even if the next generation participates in their parents’ real estate via an asset-managing partnership, externally financed real estate can have unintended income tax consequences.
If a parent establishes an asset management partnership with their offspring and contributes a rented property that is financed by a bank loan retained by the parent, the parent’s debt interest deduction is also only permitted in the amount of their participation quota. If the loan is taken over by the partnership, this may result in a private sale within the meaning of Section 23 EStG if the ten-year period for the real estate has not yet expired.
In the case of a planned transfer of real estate free of charge, particular caution is therefore always required if external financing exists for this. In this case, comprehensive and careful tax advice should be sought in advance of the gift.
Continue reading:
German Estate Planning and Inheritance Law
Inheritance and Gifting of Real Estate in Germany: Tax Advantages for Third Countries Too
