I currently own a rental home for the last 7 years and recently paid off the mortgage on the home. I have been taking depreciation and claiming expenses on it all of that time. I am thinking of doing one of two things with the home, 1) put it on the market and selling it for what I paid for it, or, 2) give it to my son for free via a quit claim deed.
My concern is the tax ramifications of either option. I know that you can only give me a general answer without all of the specifics, but, would you have an idea of which option would have the least tax consequences?
I currently have an income of around $100k and take the standard deduction on my taxes (in addition to the depreciation on the rental home) and live in Michigan.
What are you actually trying to do? Give your son a home? Give your son money? Because those two things are really different, and not just in terms of taxes.
For both plans, you need to know your current adjusted cost basis on the home. Your adjusted cost basis is the price you paid, plus any permanent improvements you paid for, minus depreciation you claimed or could have claimed as the property was a rental.
Now if you sell,
You may have a capital gain. Your gain is the difference between your selling price and the cost basis. Lets say the property really hasn't appreciated and the current fair market value is the same as the price 7 years ago. Suppose the house cost $100,000 and you have claimed $20,000 of depreciation. You sell it for $100,000 and your selling costs are $6000 (real estate commission). You have a capital gain of (94000 minus 80000 equals) $14,000. Because this gain is less than your depreciation, all the gain as taxed as depreciation recapture, which means it is tax at ordinary income tax rates with a cap of 25%. If you're single, you're in the 22% bracket which is what the recapture will be taxed at.
If you have a larger gain -- say the home sells for $120,000 -- then the first $20,000 of gain is taxed as depreciation recapture at 22% and the remaining $20,000 is taxed as long term capital gains at 15%.
If you give the home to your son, the consequence for you is that you have to file a gift tax return for the fair market value of the gift. Giving a gift is not taxable as long as your lifetime gifts are less than $11 million, but gifts over $15,000 per person per year must be reported to be counted against your lifetime limit.
The consequence for your son is that you give him not only the house, but you also give him the ownership history and the adjusted cost basis. His cost basis will be whatever your current basis is now ($80,000 in my example). If he lives in the home as his main home, then whenever he decides to sell it, his cost basis for calculating his capital gains at the time will be whatever your cost basis is now. He will also have to pay depreciation recapture tax on the part of his gain that is due to your depreciation, even if he otherwise qualifies for the homeowner's capital gains exclusion.
If your son places the home in service as a rental, his basis for depreciation will be the current adjusted cost basis (minus the value of the land), and not the current market price or even the price you paid. He starts the depreciation clock from where the house is now. Then if and when he sells the rental, his taxable depreciation recapture will include both his depreciation and yours.
So make sure that you provide him copies of your depreciation schedules and other tax paperwork so that he can prove his cost basis and tax position when he sells.
However, your son does not owe any tax now for receiving a gift, since gift recipients are never taxed in the US.
Finally, if you happen to be elderly or in poor health and are thinking of giving the house to your son to avoid the government taking it should you require long term care, you should be aware that Medicaid has a 5 year clawback rule and your son could be forced to return any large gifts made to you in the 5 years before you required care, so that you can use those gifts to pay for your own care before the government takes over. (You can't give property away to make yourself poor enough to qualify for assistance.) So see an Elder Law Attorney if that is the sort of event you are planning for.
if you sell the property you'll recapture as 1250 gain all the depreciation taken. since you say the sales price will be equal to your original cost. section 1250 gin is taxed like ordinary income but at a maximum rate of 25%. you do not have recapture if you gift it to your son but he will have to recapture the depreciation you took if he sells the property and has a gain (recapture can not exceed the gain)
for him to know the basis of property received as a gift, he must know your adjusted basis, the depreciation you took, and the FMV at the time it was given to him.
First off, My apologies for not replying to your message sooner. I just saw your reply tonight as it went into my spam folder (which I obviously do not check often). I really appreciate your comments and the comments of the others in explaining my options.
The bottom line of what I am trying to do is pass the home onto my son and do it in a way that will minimize taxes for both of us.
One of the things that I was told recently was that, in the state of Michigan, if you live in the rental home for 2 years out of 5 years it can be considered a personal residence and no additional taxes would be due. Hopefully this is true. If so, I would add my son to the property deed (along with me) and he would live in the house for 2 or more years and not have to pay additional taxes. After that time, I would remove myself from the deed and it would be his home solely. Is this thought process correct?.
Not under federal law. Under federal law, if you added your son to the deed to make him an owner, and then he lived in it as his primary residence for two years, he would qualify for the capital gains exclusion on his primary residence. However, the exclusion is modified by something called a period of non-qualified use. This is somewhat difficult to explain in brief language, and the IRS does not even cover it in the current version of publication 523 on the sale of your home. (The calculation for nonqualified use is included in the worksheets, but there is no description of what it means.)
Basically, the non-qualified period rule means that you cannot convert the taxable sale of a rental property into non-taxable sale of personal property simply by moving into it for two years. If this was a rental property for seven years and a personal residence for two years, then seven years are non-qualified and two years are qualified. When your son sold the home, he would be able to apply 2/9th of the capital gains to the personal exclusion, but the other 7/9th of the capital gains would still be taxable. If your son lived in the home for five years before selling it, then 7/12 would be non-qualified and 5/12 would be qualified. And so on. Because the home would be a gift from you to your son, his adjusted cost basis for determining his capital gain would be the current depreciated basis after being a rental for seven years.
In addition, the depreciation recapture must always be paid, no matter who lives in the home and for how long.
The only sure way for your son not to owe any capital gains tax when selling the home is to inherited after you died, because he would receive a stepped up basis.
I suggest you see a financial planner for advice on any strategies that might reduce the tax owed. And I don’t know about Michigan law. But under federal law, whenever that home is sold, the seller will have to pay the depreciation recapture and capital gains on the appreciation that occurred during the period of time that it was a rental.