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Re: Tax on giving rental property as a gift

We seem to have been sidetracked on depreciation ... a few basic questions:

If I gift a depreciated rental property to my child, I understand their basis in the property is the same as mine. 

1. If my child uses the property as their primary residence (for at least two years), do they (or I) owe any taxes on the gift (capital gains, income, gift tax, or otherwise)? 

2. When my child eventually sells this primary residence, will they owe taxes (capital gains, income, gift tax, or otherwise)?

3. (less important question - if not answering all, please focus on #1 & #2) There was some talk of a "sham" to avoid taxes - I don't understand this implication.  If one is following the rules, as written, how is it a sham?  Is this an arbitrary power based on the opinion of the auditor?  Assuming one is following all the rules ... isn't that adequate?  Where does one draw the line here?  If an executive receives compensation (stock based programs) that are taxed as capital gains (instead of income), and this transaction is following the rules, would that be a sham (since the auditor "feels" like income taxes are being avoided)?

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6 Replies

Re: Tax on giving rental property as a gift

1. The gift is valued for tax purposes at the fair market value on the date of the gift, regardless of the basis.  If you give your child a home that you previously used as a rental, and the adjusted basis after depreciation is $100,000, but the fair market value is $250,000, then the gift is valued for gift tax purposes at $250,000, the present FMV. (Both the FMV and the adjusted basis are reported on form 709.)

 

A gift recipient never owes gift tax.  The giver is required to file a gift tax return form 709 to report any gift of more than $16,000 per person in a year.  However actual payment of gift tax is only required if the giver's lifetime gifts total more than $12 million.  Form 709 is used to keep track of large gifts against the lifetime exclusion limit.  Form 709 is due at the same time as a tax return, i.e. April 15, 2024 for a gift made during 2023.  However, form 709 is filed separately, it is not part of a regular tax return, and Turbotax does not prepare this form for you.

 

The requirement of the giver to file form 709 is based on the date and value of the gift, it doesn't matter what the recipient does with the property.

 

2. Whenever the recipient sells the home, they will calculate and owe capital gains tax on any capital gains.  If they lived in the home as their main home at least 2 years of the previous 5 years, and owned it at least 2 years, they can exclude the first $250,000 of capital gains (or the first $500,000 if married filing jointly).  However, the depreciation must be recaptured first.  Suppose the FMV on the date of the gift was $250,000 and the adjusted basis after depreciation was $100,000.  Two years from now the recipient sells the home for $400,000.  They have $300,000 of capital gains,  The first $150,000 is depreciation recapture and is not eligible for the exclusion, recapture is taxed as ordinary income with a cap of 25%.  Then, the next $150,000 is eligible for the exclusion and will be tax-free if the owner qualifies for the exclusion. 

 

3. I think you are copying from another discussion and I don't know what was referenced there.

 

My guess is that the thinking was as follows.

 

Suppose you were to sell the home for $400,000 having only been a rental.  You would owe depreciation recapture on $150,000 and long term capital gains on $150,000.

 

Or, suppose you moved back into the home and lived there two years, then sold it for $400,000.  You would owe depreciation recapture on $150,000, and then because of the "non-qualified use" rule (which I can explain separately if needed), you might pay capital gain on $100,000 of the gain and only qualify to exclude $50,000 of the gain.

 

Or, suppose you give the home to a family member who lives there two years and then sells it.  They owe depreciation recapture on $150,000 but the rest is tax-free.  

 

So by giving the home to a relative who waits 2 years before selling it, you have avoided paying the IRS $22,500 in long term capital gains tax.  So a question the IRS might ask is, was this a legitimate gift, or was it part of a scheme to pay less tax?  Did the child really live there as their main home, and was it a free will, no strings attached gift, or were the child and parent working together to pay less tax?

 

I don't know who raised this originally, and I don't know how it would be handled in court.  The IRS is allowed to adopt a "substance over form" doctrine, meaning they can tax a transaction based on what they think really happened even if it looks like it happened differently "on paper".  But this would probably end up in Tax Court and someone under this kind of investigation would probably have legal representation.  The first question would be, does this look like a legitimate gift or part of a scheme?  That depends on all the facts and circumstances.  Maybe the child moved into the house with their partner/spouse and child, and only sold because of a job change or other move.  Or maybe the parent has several such properties and this is the third time in a row that the child has been gifted a property that they sell after 731 days.

 

I agree it's murky, and I think it is unlikely that most gifts of this type would be questioned.  I don't know what gave rise to the suggestion in the past. 

Re: Tax on giving rental property as a gift

Also note that in tax law, there is no such thing as innocent until proven guilty.  All your income is presumed taxable unless you can prove otherwise.  As the Tax Courts have stated many times, “deductions are a matter of legislative grace”, and the taxpayer has the burden of proving that a deduction exists in the law and that they qualify for it.  In other words, if your child sells a home for $400,000 in my example, the entire amount is presumed taxable unless they can prove they are entitled to a basis adjustment (on the basis of the gift and your prior depreciation) and they can also prove they qualify for an exclusion under the 2 year rule.  That gives the IRS all the authority they need to investigate whether the events that gave rise to the adjustments actually happened.  

Hal_Al
Level 15

Re: Tax on giving rental property as a gift

Q. If my child uses the property as their primary residence (for at least two years), do they owe any taxes on the gift (capital gains, income, gift tax, or otherwise)? 

A. No. As others have said, a gift is not taxable to the recipient.  How long they live in it is irrelevant, for whether the gift is taxable.

 

Q. When my child eventually sells this primary residence, and they lived in it more than 2 years, will they owe taxes (capital gains, income, gift tax, or otherwise)?

A. Yes.  They will owe capital gains tax and  tax on the depreciation recapture (section 1250 gain). But, they will qualify for a prorated home sale exclusion.  The gain will be prorated between the residence time and the rental time (even the time before they owned it). Only "non qualified use" after 2008 is prorated. Deprecation since May 6, 1997 must still be recaptured, even in a  home sale exclusion situation. The recaptured depreciation is not included as a part of the exclusion calculation.

For details see a similar question at:

https://ttlc.intuit.com/community/tax-credits-deductions/discussion/re-gifted-rental-property/01/173...

 

Q. There was some talk of a "sham" to avoid taxes.  

A.  Any sham you can think of, the IRS is already aware of it and has written rules for it.  In this case, the new owners only get to exclude the amount related to their limited residence time. Tax is still due on the rest.  There is no "sham" in your case.

Carl
Level 15

Re: Tax on giving rental property as a gift

1. The gift is valued for tax purposes at the fair market value on the date of the gift, regardless of the basis

The way you worded that can be misleading if the method of determining the FMV is not clarified. The basics are at https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/prope...

 

Re: Tax on giving rental property as a gift


@Opus 17 wrote:

 

3. I think you are copying from another discussion and I don't know what was referenced there.


 

 

Lately, there have been "replies" that have somehow become their own thread.  I don't know if a Moderator does it, a Champ does it, or if the user does it.  But it has been happening from time to time (I get a notification that somebody responded to a post but it brings me to a new post that I've never commented on).

 

In this case, it seems to have been pulled out at a bad time because we seem to be missing quite a bit of context.

Carl
Level 15

Re: Tax on giving rental property as a gift

ately, there have been "replies" that have somehow become their own thread.

That is definitely what happened here, as the thread this is attached to is not the one I replied to with my response.

 

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