Sell and Gift or Gift and Sell Rental

[DaveO]

Clients own a rental house worth $150,000 subject to a $50,000 mortgage with adjusted basis of $75,000. They wish to sell the property and gift the proceeds after mortgage and taxes to one of their parents. They are in the 25% bracket so this will only be about $10,000.

If they were to gift the property to parent subject to the mortgage and the parent sold it the parent would pocket far more due to their lower tax rate. Am I correct is assuming the Clients would have no issue with the debt relief since they are gifting more equity than they are receiving in relief? Since parent never benefited from depreciation they would have no Section 1250 gain either. Transaction cost and all must be accounted for and all gift tax returns will be filed but I am missing something here?

[Gary2]

If sold immediately after gift, it raises the question of whether this is really an attempt to transfer income (substance over form).

If they gift subject to the mortgage, the mortgage lender will have a say in the matter. Perhaps that's already been addressed.

If it's gifted, parents get the clients' adjusted basis for depreciation purposes, which makes me dubious about the 1250 gain. Section 1250(b)(3) defines depreciation adjustments as such adjustments to the basis "allowed or allowable to the taxpayer or to any other person" (emphasis added).

[Roland Slugg]

I wouldn't worry about the IRS trying to assert that the house was sold by your client and not the parent. As long as there is a bona fide gift, and the deed is re-titled in the parent's name, it should be fine.

The potential for Unrecaptured §1250 Gain will be the same in the parent's hands as in the current owner's. It's a function of the amount of depreciation taken on the property, regardless of who sells it. You didn't say how much depreciation has been taken, so we don't know how much Unrecaptured §1250 Gain there will be. If the entire gain consists of Unrecaptured §1250 Gain, the federal tax will be nearly $19k, not the $10k amount you indicated.

If the parent is in a very low tax bracket, some of the $75k gain might escape tax altogether, as I'm sure you realize. Also, the tax rates applied to the Unrecaptured §1250 Gain may be lower for the parent than for the current owners.

Before proceeding try to estimate the additional costs involved in doing a gift then sale. There will be a second set of "escrow costs" of various kinds, and they could amount to a sizable total. I would talk to an escrow officer at a title or escrow company about those.

[Burke]

I wouldn't think a gift of the property would consist of any more expense than the writing of a new deed (about $350) plus the recording costs of same. Maybe a grantor's tax depending on locality. There shouldn't be anything to escrow. The local deed registrar could give you all those expenses up front.

[buzzardbreath]

Gift reportable but not payable

I do believe Gary2 that this is substance over form, but the existence of gift tax laws are designed to accommodate this as long as properly done, and the IRS acknowledges this without complaint.

There should be no gift tax in terms of dollars paid. Most likely the "taxable" amount will simply be deducted from the unified exemption and no tax will actually be paid unless the unified exemption someday is exhausted. This kind of discussion ignores state taxes since some states actually do levy a tax on a gift and have no such "unified exemption."

[DaveO]

Thank you all for your input. I don't know the parents tax situation yet, only my clients. This is good food for thought. It is their intention to sell, then gift. I'm just looking for a way to improve the outcome.

[Burke]

You will find much discussion by tax/financial planners regarding this issue, generally referencing stocks. It is perfectly permissible to transfer such assets to another party, and then have them sell those assets, taking advantage of the lower tax bracket. There is no exception of this rule for real estate that I know of, as long as it is a complete and arms-length transaction. The tax avoidance situation would come into play if the donee then subsequently returned the monies to the donor. Then, the intent is not really to gift at all.