The way rental property is sold alters tax bite

Q: My daughter was recently divorced and is moving from Denver to Albuquerque. I have three rental houses and am considering giving her one of the houses to live in here. I know that, if I sell the house, I have to pay tax on the gain because it was a rental to me. I have also been told that, even if I live in a rental for two years to qualify for the special tax exclusion and then sell, I still have to pay a lot of tax. I am hoping that, if she lives in the house for at least two years, she will be able to later sell and not be penalized because I used it as a rental.

A. If your daughter lives in the house as her principal residence for at least two years before she sells, she will get a better tax result than anything available to you.

To see this, let’s go through a simple illustration. Let’s say the house was purchased for $100,000 and sold for $200,000. It was rented for six years and then used as a principal residence for two years before sale.

We also need to know how much depreciation was claimed during the rental period, so I’ll assume that is $10,000. With an initial purchase cost of $100,000 and $10,000 of depreciation, the tax basis, used to determine gain from sale, is then $90,000.

There are then two provisions that will affect the answer. First, when a rental property is converted into a principal residence, the rental use is called “nonqualified use.”

If the owner occupies the property as a principal residence for at least two years, the maximum tax exclusion available to gain from sale does not apply to the gain allocated to the period of nonqualified use.

Second, when a principal residence is sold, the exclusion does not apply to the gain caused by claiming depreciation. In our example, $10,000 of gain will be created by depreciation because it reduces the tax basis of the property.

Now let’s examine three possible sale strategies for one of your rentals. First, you sell it while it is a rental. Second, you use it as a principal residence for two years, followed by a sale. Third, you gift it to your daughter, who lives there for two years and then sells.

If you sell while the property is a rental, the gain is $110,000 ($200,000 sales price minus $90,000 tax basis). All of this gain must be recognized. This is the worst tax alternative.

Second, you move into the house and use it as your principal residence for two years. You will first recognize the $10,000 depreciation claimed as gain. Then, of the remaining $100,000 gain (the appreciation), 6/8ths does not qualify for the exclusion.

This means that an otherwise-allowable $250,000 exclusion is reduced to $62,500. In our example, $37,500 of gain would be recognized by nonqualified use.

The reduced exclusion ratio is based on the period of nonqualified use (six years) to the total period you owned the property (eight years). Because some of the gain

is excluded, this option is a better tax result than the first one.

The third option is to gift the property to your daughter, who then lives there two years and sells. The rule that requires that depreciation claimed be reported as gain is based on whether the depreciation reduces the basis of the property.

Property acquired by gift takes the same basis in the hands of the recipient as it had to the person making the gift. Your daughter’s basis is then reduced by your depreciation and this means she must recognize the $10,000 depreciation claimed as gain, just like you would be required to do.

But the “nonqualified” use provision refers to use by “the taxpayer,” which means the person selling the property and seeking to use the exclusion. Because your daughter’s use will be only for qualified (residence) purposes, she will not be tainted by the rental period.

So your daughter will be able to report only $10,000 of gain (using my made-up numbers). This is the best tax alternative.