Q: I will gift a rental house to my daughter and her husband. The house is worth about $365,000 with a $62,000 mortgage, but I will pay the mortgage before transferring the title. I know I have to file a gift tax return but my estate is between $4 million and $5 million so I will not owe any gift tax. My concern is my daughter’s ability to use the $500,000 gain exclusion if she sells the house. She has two children and a third on the way and currently lives in an apartment. With the equity from this house they may later sell and move to a larger home. The concern I have is my prior rental of the house. I have never lived in the home and my tax basis at the end of 2021 was $164,117, which is after claiming a total of $49,110 of depreciation. If I sold now I would have a large tax liability. Can she and her husband avoid any tax if they live in the home for at least two years after the gift is completed? I’m afraid if they succeed to my tax liability it will be much harder for them to trade up to a larger home later.
A: I can’t give you a precise figure for their potential tax liability without knowing more about their tax situation. However, I think they may owe between $10,000 and $15,000 if the house is sold after they live there for two years.
This estimated tax is far less than you would pay if you kept and sold the house. For that reason, I think the gift remains a good idea even if they incur a small tax burden.
There are several steps to get to my answer. First, the tax law allows a seller of a residence to exclude $500,000 of gain if they owned and used the home as a principal residence for two of the five years before sale.
Second, the seller must recognize gain to the extent the property has any “depreciation adjustments” for periods after May 6, 1997.
Your depreciation must have all been after 1997 based on the amount of accumulated depreciation. So all of the depreciation claimed by you is subject to the special rule.
Of course, your daughter and son-in-law were not the beneficiaries of this depreciation. However, their tax basis in the house will be the same as yours, adjusted through the date of the gift.
The way the law defines “depreciation adjustments” does not depend on who claimed the depreciation, only that it adjusted the tax basis of the property.
Because your daughter’s tax basis is affected by the depreciation that you claimed, she will be the party required to recognize gain when the property is later sold. The $500,000 exclusion cannot protect that gain.
Third, there is another adjustment to the allowed exclusion when the property was used for some purpose other than as a principal residence. This is called “nonqualified” use and it reduces the allowed exclusion if the use occurred after 2008.
The nonqualified use rule would apply if you occupied the rental for two years and then sold. It will not apply to your daughter and her husband.
Nonqualified use must be by “the taxpayer” who sells the residence. By contrast, the depreciation adjustment applies if the depreciation is allowed “to the taxpayer or to any other person.”
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The end result is that your daughter and her husband will recognize gain for the depreciation that you claimed on the property. You say it is $49,110 but it must be adjusted to include what is allowed in 2022 through the date of the gift.
The federal tax rate on this gain cannot exceed 25%, but may be less than that based on your daughter and son-in-law’s income.
There may also be a 3.8% surtax at the federal level, but this surtax applies only to higher income taxpayers. New Mexico currently allows a 40% exclusion for capital gains, so the rate cannot exceed 3.54%.
The $10,000 to $15,000 tax estimate is just a guess. However, your daughter and son-in-law will incur some tax liability on a future sale.
James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected].