Giving rental property to son reduces tax burden

Q: I have a rental property that I want to gift to my son and his wife. I bought the property about 17 years ago for $180,000, and it’s worth about $270,000 now. I have rented it continuously and claimed about $95,000 in depreciation. If I sell this property, I’ll have to pay tax on a gain of $185,000 so it makes more sense to gift it. It is my understanding that if my son lives in the house for two years he’ll be able to sell and have no gain on his tax return. I want confirmation that this is true.

A. It’s partially true. If your son acquires this house by gift, lives in it as his principal residence for at least two years and then sells, he will have a $95,000 gain to pay tax on.

This is still better than the result if you sell the house. The steps to get to the answer are a bit convoluted, so let me go though it step by step.

Let’s start with what happens if you sell the house. Your adjusted tax basis is now $85,000, which is your original cost of $180,000 reduced by the $95,000 depreciation you have claimed.

If you sell for $270,000 your gain will be $185,000. So you and I agree on the answer under that scenario.

Now let’s change the facts a bit and say that you decide to move into the house and make it your principal residence for at least two years. This allows you to use the special tax exclusion for gains from the sale of a principal residence.

In general, the exclusion allows you to avoid tax on as much as $250,000 ($500,000 if married filing joint). But there are a few exceptions that will prevent you from using the full exclusion.

First, you must recognize gain up to the cumulative depreciation deductions claimed on the property. So you must recognize $95,000 of gain even if you convert the rental to your residence for two years.

Second, where the house was previously used as a rental, the exclusion is available only for the percentage of use as a residence to the total use of the property.

For the $90,000 gain not caused by depreciation deductions, your exclusion would be limited to 2/19 (based on two years of residence use to 19 years of total use) of $90,000, or $9,474.

The rental use is called “nonqualified use,” and no exclusion is available for gain attributable to periods of nonqualified use.

So at this point it’s an ugly answer for you. There are two provisions that cause you trouble: the requirement to recognize gain for prior depreciation claimed and the allocation between qualified and nonqualified use.

With that, let’s turn to what happens if you give the house to your son. It becomes a “good news-bad news” result. I’ll start with the good news.

The qualified-non-qualified use rule applies only to the taxpayer who used the property for a nonqualified (not a principal residence) purpose. That is you, so your son will avoid the nonqualified use rule.

But your son will not be able to avoid the rule that gain must be recognized for prior depreciation claimed. This is so because the tax penalty applies when the depreciation reduces the tax basis of the property, without regard to who claimed the benefit of the depreciation.

Your son will take over your tax basis when you give the house to him. This means his tax basis will be $85,000, which is your original cost adjusted for the depreciation claimed.

If he lives in the home for two years and then sells, his gain will be $185,000, just like yours, if we assume the same $270,000 sales price. In a “normal” sale by someone who had nothing but principal residence use, this entire gain would be excluded.

However, the depreciation rule says gain is recognized if the basis of the property has been adjusted by depreciation claimed. It says nothing about who claimed this depreciation.

Your son would then be required to recognize a $95,000 gain from a sale after two years of qualified residence use. This is still much better than your result.