Mother and Son own duplex occupied by Son

[Trusteeof3]

1) Mother bought duplex in California in 1980 for let's say, $100k, and made capital improvements of $50k.
2) Mother rented out both sides of said duplex.
3) Son moved into one side of the duplex along the way and paid rent.
4) Mother sold half interest to Son in 2017 for $417k. Son continued to live in one side; renters occupied the other. Son financed the sale with a mortgage. Son paid the mortgage and property taxes. Mother collected some rent, with the agreement that she would report all of the rent as income. Son deducts all mortgage interest (only his name is on the 1098) and all property tax.
5) Mother dies in 2021. 100% of property passes to Son as "Joint Tenant with Right of Survivorship." Let's say the FMV at death was $900k.

Questions for Mother's back taxes that were never filed:
1) Must Mother recapture depreciation of 50% of purchase price plus capital improvements (since it was more than 27.5 years) on her 2017 return? So 50% of $150k is $75k, times 25% recapture tax would be $18.75k?
2) Must Mother pay capital gains on $417k - $150k/2 = $417k - $75k = $342k on her 2017 return?
3) Was Son allowed to deduct all mortgage interest and property tax?
4) Is Mother allowed to report all rental income since sale in 2017?
5) Depreciation: after sale to Son in 2017, I understand that there is no further depreciation for Mother or Son since rental "side" was fully depreciated. Correct?
6) Should Mother or Son have paid the California Franchise Tax of 3 1/3% of $417k?

After Mother's death:
1) Is half of FMV at death stepped-up for Son? So his new basis for capital gains when he sells is half of the FMV at death ($450k), plus his purchase price of $417k = $867k?
2) Does Son's depreciation begin all over again at that same basis?

Thank you for your time. As you can imagine, it is difficult to google this exact scenario.

[GeorgeM777 · Accepted solution]

Question 1 - Yes, the sale of one-half of the duplex to son should have triggered depreciation recapture for one-half of the property.  For California taxes, the depreciation period for residential rental property is 45 years. So that requires a separate set of calculations.

Question 2 - Yes, it appears there was a long-term capital gain on the sale to son of one-half of the property.  However, California taxes long and short term capital gains as regular income.  No special rate for long term capital gains exists. 

Question 3 - If the son was actually paying the mortgage interest and property tax, then the son can take the deduction for those items. 

Question 4 - Yes, because mother was collecting rent, the mother should report that rental income on the return for the year in which the rental income was collected.

Question 5 - Yes, it appears that the cost of the property was completely recovered and thus, there is no further depreciation to claim at least on the federal return.

Question 6 - Perhaps, if no exception applies.  You do not have to withhold tax if the CA real property is:

• $100,000 or less
• In foreclosure
• Seller is a bank acting as a trustee
• See Form 593, Part III for a complete list of full exemptions, and Part IV for full or partial exemptions.

Question 6(1) - Yes, it is the value of the property on the mother's date of death.  But there is the option to use the FMV of the property on the alternate valuation date, but only if the executor of the estate files an estate tax return (Form 706) and elects to use the alternate valuation on that return. See the Instructions for Form 706.

Question 6(2) - the son's depreciation would begin on the day the property is placed in service.  On the federal side, the cost basis to use for depreciation purposes is the lesser of (1) the fair market value of the property or (2) the owner's adjusted cost basis.  

@Trusteeof3

[Trusteeof3]

Thank you so much, @GeorgeM777 for your answers and the additional information for California.

Just to confirm, the amount Son depreciates going forward would be 1/2 of the new total basis for the duplex (assuming the FMV increases year to year)? The rental side of the duplex has continually been in service since 1980.

Your answer to 6(1) has me thinking further. Doesn't the change to "Joint Tenant with Right of Survivorship" bypass the estate, or in this case, the trust?