Starting with a very basic setup. Child buys a home, parents co-sign the loan, bank requires the parents be listed on the deed as well. Child lives in the home and pays all the bills, and takes the tax deduction for mortgage and property taxes. The facts would show that the child was the 100% owner in fact, even if not in name, and the child could report the gain only on their tax return and use the $250,000 personal capital gains exclusion.
Once you start complicating things with the rental, Mike's questions become very important. Did you file tax returns as if the child was the sole owner, the child reported all the rental income, deducted expenses and claimed depreciation? Or you did you file taxes as if the ownership was divided 2 ways (child and parents) or 3 ways (child and two individual parents)? Who deducted the property taxes for the rental portion on schedule E? Who deducted the property taxes and mortgage interest on schedule A?
If you established a new fact pattern, where you are co-owners and co-landlords, you may be stuck with that fact pattern. Parents and child may need to split the sales proceeds and each report a share of the capital gains. Child can claim the capital gains exclusion on their portion of the gain, but parents will owe capital gains tax on their portion.
The bottom line is that you can't treat the property as co-owned when it is convenient to do so (such as a rental) but claim it was really owned by the child when it later becomes convenient to claim that.
