Getting a Real Estate Gift Could Have Tax Consequences

The Basis of Gifted Property Can Hurt You at Tax Time

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The tax basis of gifted property can be tricky. Just ask Beverly in Atlanta, Georgia, who writes:

"My dad, 90 years old and in apparent good health, gave me his rental condo in Florida. I have been renting it to vacationers. The condo was originally purchased in 1975 for $65,000 and it is now valued at $550,000. I am an only child and will inherit everything at my dad's passing. 

My question is: Did he make a terrible financial mistake by giving me this condo instead of leaving it to me in his will? I have been told that if I sell, which is likely in about two years, I will have to pay thousands in capital gains tax, and that this wouldn't be the case if I had inherited it.

I have two sons who will inherit everything I have. Should I 'sell' the condo back to my dad to avoid the taxes I'd incur if I sold it? Then if I decided he needed to sell it in the next year or so, would he pay taxes only on the difference of the present day value ($550,000) and whatever he got above that amount?

But if I sell it back to him to avoid the capital gains taxes and I inherit it when he passes, and if I THEN sold it, what amount would I pay taxes on? I need to know what to do. When I mentioned to my accountant that my dad had just given me the condo, he said, "You know that was a big mistake tax-wise." What are the repercussions of all my options? Thank you very much."

Although it's immensely generous, making a gift of real estate often comes with several disadvantages from a tax perspective. Some tax professionals advise people never to give real estate. I think that's a little too harsh because I can imagine scenarios where giving real estate can be a smart tax move. However, this isn't one of those situations.

Capital Gains on Gifts vs. Inheritances 

In general, you should prefer inheritances rather than gifts of real estate. Here's why:

The executor of your father's estate will value all the property in his estate as of the date of his death. The executor will also value all the property again six months after the date of death. He can then choose whichever valuation date results in the least possible estate tax consequences. As an heir, your cost basis in the property will be the fair market value on the chosen valuation date, not its initial purchase price.

This is called a "stepped-up basis" and it's an excellent way to minimize your capital gains tax liability if you later sell the property.

The recipient's cost basis is the same as the donor's cost basis in a gift situation. This makes gifting a less favorable way of transferring assets, although gifting can be an excellent strategy for shifting capital gains to family members who have lower tax rates.

For example, let's say you're sitting on long-term capital gains on some stocks, and those gains would be taxed to you at 15 percent. You can gift those stocks to another family member with little or no income and the gains would not be taxed if he's in a 10 or 15 percent tax bracket. The taxable amount of the gain is the same in either situation so gifting is simply a way of choosing a more favorable tax rate on appreciated investments.

Capital Gains on Rental Property 

Your cost basis in the gifted condo is the same as your father's cost basis because you received it as a gift. So if your dad purchased the property for $65,000, that's your cost basis as well. You'll need to carefully review your "adjusted cost basis" in the property, too. I provide the formula in my article on Reporting Rental Income on Schedule E. Your cost basis is reduced even more by the amount of depreciation you and your father claimed or could have claimed as tax deductions.

Furthermore, the gains on the rental property will be taxed at two different tax rates: ordinary income tax rates on the amount of the gain attributed to depreciation and long-term capital gains tax rates on any gain left over after depreciation has been accounted for.

This is called depreciation recapture.

What to Do? 

What you should do now depends entirely on how long you plan to keep the rental property. If you were going to keep it for the rest of your life and pass it on to your children as an inheritance, there's really nothing you need to do right now. But you indicated you might want to sell the property in the next few years. Someone will have to pay the tax on the capital gains when this happens, either your father or you or someone else. You should sit down with a tax professional and plan out the tax consequences of various strategies. Figure out which strategy will save the most tax.

Your possibilities include:

  • Keep the gift: You'll be on the hook for taxes if you sell the property. But if you hold the property until you die, the basis will step up and your heirs can sell it and shelter some of the capital gains.
  • Undo the gift: I'm not sure if this particular gift can be undone, depending on how many years have passed since the original gift. You might want to check with an attorney. 
  • Give the property back to your father: His cost basis will be the same as your cost basis, which is to say that it is your father's original cost basis as adjusted for depreciation and other factors. Your father could then sell the property or hold it until he dies.
  • Give the property to someone else: The idea here to choose someone else, perhaps your children or another relative, for the most favorable tax consequences based on that person's income. 
  • Give the property to charity: A charity can take all the gains tax-free.