Gifted Rental Property

[Arif1]

My dad is planning on gifting his rental property to me and my brother 50-50 ownership. Our plan is to move into the property for 2 years and then sell the property. A few questions. As we are both married and we are going to live in the house for 2 years, do we both qualify for the FULL $500k exclusion OR will we be subjected to the non qualified use rule for the years the property was rented prior to us receiving it as a gift? Or do the years prior to receiving as a gift not count as that relates to a different owner? Also, when we sell will we be subjected to any depreciation recaptured that occurred from depreciation claimed prior to us receiving the property as a gift?? 

[Hal_Al]

Seek competent legal/accounting/tax help before doing this. It's complicated.

That said;

Q.   Do we both qualify for the full $500k?

A. Yes. Your spouse(s) must also meet the 2 year residency rule, but does  not need to meet the ownership rule.

Q.  Will we be subjected to the non qualified use rule for the years the property was rented prior to us receiving it as a gift? 

A.  Yes. The gain will be prorated between the residence time and the rental time.  So, yes,  the years prior to receiving it  as a gift do count for the new (different) owners.  Only "non qualified use" after 2008 is included in the calculation. 

Q. Will we be subjected to any depreciation recaptured that occurred from depreciation claimed prior to us receiving the property as a gift?

A. Yes.  Your cost basis is the  gift  giver's basis, including any deprecation "allowed or allowable". Deprecation since May 6, 1997 must still be recaptured, even in a  home sale exclusion situation.

Reference: https://www.kitces.com/blog/limits-to-converting-rental-property-into-a-primary-residence-to-plan-fo...

A question you didn't ask:

Q. Will Dad be subject to the  gift tax filing requirement?

A. Yes, depending on how the $15,000 exemptions are split up.  But "Gift Tax" is somewhat of a misnomer.  Even though a gift tax return may be required, very few people ever actually pay federal gift tax. The purpose of the gift tax return is usually only to document a reduction in the allowable estate tax exemption.
See https://turbotax.intuit.com/tax-tools/tax-tips/Tax-Planning-and-Checklists/The-Gift-Tax-Made-Simple/...

[Critter-3]

PLEASE seek local professional assistance in this matter ... gifting  depreciated property is complicated to both the giver and receiver  especially when you go to sell ... you need to understand exactly how this will be reported on your tax returns.  The IRS has strong rules in place to keep people from changing a taxable event into a non taxable event to avoid paying taxes  so the gifting must be done properly. 

[Opus 17]

Bad plan. You and your dad cannot avoid the tax consequences of his rental activities by putting the house in your name for two years.  Get competent legal and tax help before you do this.

[Carl]

My dad is planning on gifting his rental property to me and my brother 50-50 ownership.

Understand that when you are gifted the property you do *not* get a step-up in the cost basis. Your cost basis will be his cost basis. Additionally, you are also gifted "all" of his total depreciation already taken on the property, which you have to recapture and pay taxes on when  you sell the property *no* *matter* *what*. The depreciation is not excluded from taxation with the "lived in 2 of last 5" rule. You "will" pay taxes on recaptured depreciation, and that depreciation recapture will increase your AGI - potentially putting you in a higher tax bracket.

Our plan is to move into the property for 2 years and then sell the property.  A few questions. As we are both married and we are going to live in the house for 2 years, do we both qualify for the FULL $500k

exclusion

I can't say definitively, but I seriously doubt it. If the property is classified as a single family residence, then only one family can call it their primary residence.

will we be subjected to the non qualified use rule for the years the property was rented prior to us receiving it as a gift?

Lacking some clarification here. Rented to "US"???? Rented to both families? Is this rental  property a duplex where each family paid rent to live in separate units?

Or do the years prior to receiving as a gift not count as that relates to a different owner?

Yes they count. Like I said above, when a property is gifted, "everything" is gifted, including all prior depreciation and use of the property.

When we sell will we be subjected to any depreciation recaptured that occurred from depreciation claimed prior to us receiving the property as a gift??

Yes, you will be required to recapture all prior depreciation including that taken by the giver of the gift. That recaptured depreciation will be taxed too, no matter what.

Since I get the impression the transaction hasn't occurred yet, I would highly advise all parties involved to seek legal advice of both a tax attorney and a real estate attorney. If your state also taxes personal income, then you can double that recommendation.

Your situation is complex because you're dealing with two families that rented from a blood related family member and now that family member is "giving" the property to their blood related tenants. There is nothing simple about this - especially if the property is classified as a single family residence.  So in conclusion:

Seek professional help and advice  *BEFORE* you make any final decisions or taken any action.

[tagteam]

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@Carl wrote:

Our plan is to move into the property for 2 years and then sell the property.  A few questions. As we are both married and we are going to live in the house for 2 years, do we both qualify for the FULL $500k

exclusion

I can't say definitively, but I seriously doubt it. If the property is classified as a single family residence, then only one family can call it their primary residence.

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For the purposes of Section 121, there is no limitation as to the number of owners/users who can claim the exclusion @Carl. 

[Carl]

there is no limitation as to the number of owners/users who can claim the exclusion 

While possible, I just don't find it realistic that two families would live in a single family dwelling as their primary residence for two or more years. But if this is a duplex, then it's perfectly possible if each family lived in one of the units.

It's also possible for one family to live in it for two years, they move out and the other family moves in for 2 years. Then if it's sold before the 5-year mark of the first family moving in, both families would qualify. Of course, both families would also have a recapture and pay tax on their share of the recaptured depreciation too.

As a reminder to others, the 2 year count does not start until "after" your name is on the deed.

[tagteam]

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@Carl wrote:

.....I just don't find it realistic that two families would live in a single family dwelling as their primary residence for two or more years. 

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With all due respect, it does not matter what you nor I find realistic.

There is simply no limitation in Section 121 that would prohibit two or more qualified owners/users from claiming the exclusion for the same use and ownership period.

[AmeliesUncle]

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@Hal_Al wrote:

A.  Yes. The gain will be prorated between the residence time and the rental time.  So, yes,  the years prior to receiving it  as a gift do count for the new (different) owners.  

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Any citation on that?   I can't find anything that says the days the "property was owned by the taxpayer" includes days it was owned by the other person.

[Hal_Al]

Deleted

[Hal_Al]

@AmeliesUncle 

No citation.  I'm going by the cost basis, in a gift, being the giver's  basis; which I believe includes the giver's holding period, and depreciation previously  taken by the giver.

Are you saying that  that holding period only applies to capital gains and may not constitute a period of non qualified use for the new owner, for the home sale  exclusion?  There may be "related party" rules that govern.

[tagteam]

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@Hal_Al wrote:

@AmeliesUncle 

No citation.  I'm going by the cost basis, in a gift, being the giver's  basis; which I believe includes the giver's holding period, and depreciation previously  taken by the giver.

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Per Section 1223(2), the holding period of the donee would include the holding period of the donor provided the donee also takes the donor's adjusted basis per Section 1015(a).  I would tend to think, in that case, everything else would follow, including the type of use, but I cannot seem to locate any authority for that proposition (i.e., that the type of use carries over with the gift).

On the other hand, Section 1223(2) would appear not to be applicable in the event the FMV was used as the donee's basis. In that instance, the donee's holding period would appear to begin as of the date of the gift.

[Opus 17]

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@tagteam wrote:

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@Hal_Al wrote:

@AmeliesUncle 

No citation.  I'm going by the cost basis, in a gift, being the giver's  basis; which I believe includes the giver's holding period, and depreciation previously  taken by the giver.

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Per Section 1223(2), the holding period of the donee would include the holding period of the donor provided the donee also takes the donor's adjusted basis per Section 1015(a).  I would tend to think, in that case, everything else would follow, including the type of use, but I cannot seem to locate any authority for that proposition (i.e., that the type of use carries over with the gift).

On the other hand, Section 1223(2) would appear not to be applicable in the event the FMV was used as the donee's basis. In that instance, the donee's holding period would appear to begin as of the date of the gift.

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I don't see that as being an answer to whether the gain is subject to the non-qualified use rules under §121(b)(5), because section (b)(5)(B) only talks about ownership by the taxpayer, and not holding period. Certainly the brothers would have their father's cost basis, including depreciation to deal with.  

Consider the following 3 situations.

(1) The father has used the property as a rental for 30 years, moves back into the home for 2 years as his main residence, then sells it.  Original cost basis was $100,000 with $20,000 allocated to land value, the property is fully depreciated.  Property sells for $500,000.  Due to the non-qualified period rules, the father can only exclude 20/32 of his gain (the 12 years between 2008 and 2020 are non-qualified).  The total gain is $480,000.  The first $80,000 is taxed as recaptured depreciation. Of the remaining $400,000 of gain, $250,000 is eligible for the father's exclusion and $150,000 is taxed as LTCG.

(2) The father's details are the same, but the father gifts the home to his sons, who live in the home for 2 years as their main home.  They qualify for the exclusion and the non-qualified period rules do not apply.  The total gain is $480,000.  The first $80,000 is taxed as recaptured depreciation. Of the remaining $400,000 of gain, it is all eligible for the exclusion, and assuming the brothers are each 50% owners, they can each exclude the $200,000 of gain on their share.  (But they each pay recapture on $40,000.)

(3) The father's details are the same, but the father gifts the home to his sons, who live in the home for 2 years as their main home.  They qualify for the exclusion but we will apply the non-qualified period rules in this example.   Due to the non-qualified period rules, they can only exclude 20/32 of his gain (the 12 years between 2008 and 2020 are non-qualified).  The total gain is $480,000.  The first $80,000 is taxed as recaptured depreciation ($40,000 per brother).  Of the remaining gain, $150,000 is eligible for the exclusion (half to each brother as LTCG) and $250,000 is eligible for the exclusion.

Certainly scenario 3 is closest to 1 in terms of how much money the IRS gets.  But section 121 still only says owner, not holding period. (Section 121 does cover depreciation in (d)(6).)  

So go see an Enrolled Agent or other experienced licensed tax professional before you decide what to do.

[tagteam]

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@Opus 17 wrote:

I don't see that as being an answer to whether the gain is subject to the non-qualified use rules under §121(b)(5), because section (b)(5)(B) only talks about ownership by the taxpayer, and not holding period. Certainly the brothers would have their father's cost basis, including depreciation to deal with. 

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There is a concept known as "tacking" that covers the holding period, so the brothers take their father's holding period. Depreciation deductions will devolve to the brothers and the basis will, most likely, be a carryover basis (i.e., their father's adjusted basis). 

Since, as a result of the gift, the brothers will take their father's basis, holding period, and depreciation deduction (recapture liability), why would it not follow that they would also have to take their father's type of use into consideration? Is there authority stating otherwise?

If the nonqualified use did not follow (the gift) to the donee, that would be a great tax dodge for a donor with a large period of nonqualified use (as well as the donee, of course). The IRS (and Congress) probably did not intend for that to be the result of a gift of rental property with nonqualified use but, rather, that the donee step directly into the shoes of the donor (i.e., the brothers would follow your first scenario).

[Opus 17]

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@tagteam wrote:

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Since, as a result of the gift, the brothers will take their father's basis, holding period, and depreciation deduction (recapture liability), why would it not follow that they would also have to take their father's type of use into consideration? Is there authority stating otherwise?

Because I don't see anything in section 121 that would apply the tacking rules to the non-qualified use rule.  It just says 

"(B)Gain allocated to periods of nonqualified use

For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—

(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to

(ii) the period such property was owned by the taxpayer."

I agree the intent was probably to prevent the owner of a rental property from converting a taxable sale into a less-taxable sale by gifting the property.  But I don't see it in that section.  (Curiously, the inherited step-up rules supersede all of this and would make the sale completely nontaxable no matter how much depreciation was taken, so one could equally ask from the other side, if Congress wants to tax taxpayer B for non-qualified use by taxpayer A, why didn't Congress carve out an exception in the step-up rule.)

Also, there is the gift of equity to consider.  If the father has exceeded his gift exclusion limit, then the gain gets taxed twice, once as a gift and once by the operation of the non-qualified period rule against the gift recipient.  That doesn't sound fair.

Bottom line, I figure that if Congress wanted depreciation AND the non-qualified use period to follow the property to the new owner, they should have said so.  As far as I can see it just says "the period such property was owned by the taxpayer" and these taxpayers won't have a non-qualified use during the time when they own it. 

But I am not a lawyer nor an EA.  I almost kept myself out of this one, and I probably should have.