Sale of rental property with gifted equity

[dktax]

Fellow tax practitioner called with following scenario. Father sold rental property to son in Oct 2013. Dad's basis was $106000. There is $17500 of depreciation to recapture. Now it gets interesting. Purchase agreement and 1099S show sale of $113000. Equity gift of $43000 and payoff of existing mortgage $70000. Dad died in April 2014. I'm thinking Dad needs to report gain on sale and also a gift tax return. Both father's and son's tax returns are being filed now. Any opinions? What will son's basis be in property?

[Bees Knees]

This is basically two separate transactions – a $70,000 sale to report on the father's 1040 and a $43,000 gift to report on the father's gift tax return. The $106,000 basis and $17,500 prior year depreciation must also be allocated between the two transactions. I would allocate basis and depreciation in the same proportion as the sales allocation.

As to the son’s basis, it equals the $70,000 purchase price from the sales transaction, plus the portion of the father’s basis minus the portion of the prior year depreciation that is allocated to the gift transaction.

On a side note, you don't report gain or loss or depreciation recapture on a gift. So in my opinion, the portion of the depreciation allocated to the gift transaction is not recaptured by the father. It merely reduces the son's basis in the gift received.

[dktax]

That makes perfect sense

I was focused too much on the 1099S. Thank you so much.

[Roland Slugg]

Huh??? None of the above makes any sense to me. First of all, was the rental property SOLD to son or GIVEN to him? If it was sold, then the sale needs to be reported on dad's 2013 tax return ... as a sale. In that case the dad's gain is $7,000 ($113,000 less $106,000 basis), and son's starting basis is his cost ... $113,000. If it was given to him, then dad does NOT report the transfer on his 2013 income tax return, but does need to file a F-709, reporting the gift thereon. Son's starting basis in this case is $106,000 ... same as dad's. If dad sold the property to son, then turned around and gifted his $43,000 of equity, in order that son wouldn't have to pay that sum to him, then you have a sale AND a gift. In any case, no "allocation" of dad's basis needs to be made.

And what's that $17,500 of depreciation recapture? Depreciation recapture on real estate is extremely rare these days. In order to have any, the property must have been placed in service prior to 1981 when ACRS first went into effect. If you're thinking instead of "unrecaptured §1250 gain," the most there can be is $7,000 ... the amount of dad's gain. This isn't "recapture." Furthermore, if the entire transfer was really a gift, not a sale, then there isn't ANY unrecaptured §1250 gain, yet, and won't be any until son sells the property.

[Snaggletooth]

Sluggo has it right

...as bad as I hate to agree with Sluggo, he is on target. I believe Bees Knees perhaps misread the original post, as he rarely makes such a mistake, or else he may have been aware of some facts that the rest of us don't have. Maybe he is able to tune into the mindset of the original post and none of the rest of us can...

Several factual items seem to be missing. Whose mortgage payoff is involved? The son's? if the Father's then how can he pay off his own debt and have it entered into the calculation of the gain/loss? Is the basis as presented before or after the depreciation as this amount alone can tilt the scales from a profit to a loss? Why is the $113,000 selling price irrelevant?

A reader could come away from this trying to figure out how this is a gift at all? There was no mention of FMV in the original post.

Sluggo, maybe it's just you and I going nuts.

Sorry guys, the beeline just seemed to turn into a thousand winding roads...

[Bees Knees]

I believe it is sluggo and snag who mis-read the original post.

The original post says the son purchased the property for $113,000. The sales agreement describes this $113,000 as $70,000 for a mortgage pay-off, plus a $43,000 gift in equity. That translates into the son paying $70,000 in cash (which was then used to pay-off the father's mortgage of $70,000), and the other $43,000 as a gift from the father to the son.

In other words, the father signed over title to property worth $113,000 to his son in exchange for the son paying off the father's $70,000 mortgage.

Two transactions: A gift plus a purchase.

[Bees Knees]

BTW, if you interpret the original post as saying the son paid $113,000 in cash for the property and the father turned around and gave $43,000 back to the son as a gift, then the $43,000 gift would not have shown up on the purchase agreement. In that case, the $43,000 gift would have been a transaction outside of the sales agreement. The reason the purchase agreement mentions gift equity of $43,000 is because that represents money that never changed hands. For some reason, the purchase agreement was drawn up in a way that reflected the fact that the father was gifting the equity (FMV minus liability) to the son.

Personally, I would not have done it that way. If the father was selling the property to the son at below FMV, I would have only shown the $70,000 cash exchange as the sale price. Now you have a $43,000 gift transaction showing up on the father's 1099S, which has to be zeroed out on the father's 1040, since it wasn't really part of the sales price.

Perhaps the FMV was written into the sales agreement for some non-income tax purpose, such as for local real estate valuation purposes. Maybe it was a requirement under local real estate tax law.

[Roland Slugg]

I believe it is sluggo and snag who mis-read the original post.

What did we mis-read? The OP says: "Father sold rental property to son." (Emphasis added.) It also says: "Purchase agreement and 1099S show sale of $113,000." It says nothing about this being a less-than-FMV sale.

[Bees Knees]

What did we mis-read?

The part where the purchase agreement says "Equity gift of $43000 and payoff of existing mortgage $70000." I take that to read the father gifted the son his equity interest and the son paid off the father's $70,000 mortgage.

How do you interpret that phrase in the purchase agreement?

[Roland Slugg]

Aahhh, now I can see how you interpreted the transaction as you did. You were focusing on the "gift of equity" phrase, and I was focusing on the word "sale."

My guess is (and was when I first replied) that the property was sold to the son at its FMV ... $113k. The buyer/son assumed or paid off the $70k debt, and the seller/dad gifted the equity to his son at the same time ... via escrow. IMO this was a sale, followed immediately (or concurrent with) a $43k gift. If it wasn't, then where does the $113k come from? That was the property's FMV.

If my take on this is correct, I would add that it would have been better if the "gift" aspect of the transfer had been delayed until after COE, That would have made the whole thing clearer. Perhaps the original poster will return and clarify what really transpired.

[Bees Knees]

My guess is (and was when I first replied) that the property was sold to the son at its FMV ... $113k. The buyer/son assumed or paid off the $70k debt, and the seller/dad gifted the equity to his son at the same time ... via escrow. IMO this was a sale, followed immediately (or concurrent with) a $43k gift. If it wasn't, then where does the $113k come from? That was the property's FMV.

Now we are just guessing because the original poster does not make this clear.

But if the son purchased the property for $113,000 and the father then gifted the $43,000 back to the son, why put that on the purchase agreement? The gift would be after the purchase transaction. There would be no need to write it into the purchase agreement.

On the other hand, if the son merely pays off the father's mortgage in exchange for the father signing over title to the property, then the difference between the loan pay-off and the value of the property would show up on the purchase agreement as a gift in equity, because it is all part of the same transaction.

In either case, you can't tax the father on a $113,000 sale if he never received a benefit worth $113,000. Combining the gift and the loan pay-off into the same transaction (the purchase agreement) means the father only received an economic benefit worth $70,000.