Recently, the NSA Tax Help Desk assisted a member with a question regarding a partial sale/partial gift with the following conditions:
- The father bought a condo for $360,000 and rents to son for fair market rent.
- The father takes depreciation of $40,000, leaving a basis of $320,000. (Fair market value is $400,000 with a mortgage balance of $257,000.)
- The father gifted the condo to son who gets a new mortgage for the $257,000 owed.
The member decided that this situation should be treated as a partial sale for $257,000 and a gift of $143,000 because:
- The $257,000 sale is less than $320,000 basis, there is no gain and thus no unrecaptured Sec. 1250 gain. Loss from the proceeds minus basis is not deductible.
- The father’s gift of $143,000 is reportable on a gift tax return.
- The son’s basis as donee/purchaser is $257,000 paid via new loan plus donor’s remaining basis $63,000 ($320,000 minus $257,000) or $320,000.
Ultimately, the NSA member concluded the son’s basis does not include any Sec. 1250 unrecaptured gain when the son ultimately sells property. The taxpayer will be eligible to exclude up to $250,000 of gain if condo is his personal residence for two or more years out of the five-year period after he acquires the property.
NSA’s member wanted to be sure of the conclusions, so the Tax Help Desk was asked to verify that the tax pro’s logic was correct. According to the Tax Help Desk, the NSA member was right on the money.
NSA’s research staff cited the following sources* as support for the member’s conclusion:
Q-1210. Gift tax value of property subject to mortgage, lien, or claim.
If gift property is subject to a mortgage, lien, or claim, the amount of the gift is the excess of the property’s value over the value of the mortgage, lien or claim, plus accrued interest, 13 even where the donor remains liable on the mortgage. 14The mortgage or indebtedness secured by the property basically becomes the sales price.
13Janos, Minnie, (1952) PH TCM ¶53003, 11 CCH TCM 1211.
702 Transfer of Appreciated Residence to Child
702.1 Parents sometimes consider transferring ownership of an appreciating family home or rental residence to an adult child. This transaction can have significant implications for the gift and estate tax liability of the parents, and the income tax liabilities of both the parent and the child. (Transfer to a Qualified Personal Residence Trust is discussed in paragraph 703.1.)
702.2 Caution: Clients must avoid the pitfalls of retaining rights to the possession or enjoyment of the property; otherwise, the property will still be includable in the estate [IRC Sec. 2036(a)(1)].
702.3 The parent may sell the home for a bargain price to the child. This transaction is considered a sale of the home for an amount of proceeds equal to the bargain sale price coupled with a gift of the difference between the FMV of the property and the bargain sale price [IRC Sec. 2512(b); Reg. 1.1015-4]. The parent reduces the available federal estate tax exemption by the amount of the gift (in excess of the annual gift tax exclusion). If the parent has no exemption to offset the gift, a taxable gift results. The parents can offset their entire basis in the transferred residence against the amount treated as sales proceeds. If they qualify, the parents can offset some or all of the gain as provided in IRC Sec. 121 (see section 705). The child’s tax basis in the home will be the sale price plus the amount of any federal gift tax triggered by the transaction (assuming that amount exceeds the parent’s basis in the home) [IRC Sec. 1015(d); Regs. 1.1015-4 and -5]. If the child uses the home as a principal residence, any mortgage interest on financing secured by the residence should be deductible as qualified residence interest and the IRC Sec. 121 exclusion may be available on a subsequent sale. If the home has been used as a rental property, owned for over one year, and is sold for a profit, any unrecaptured IRC Sec. 1250 gain will be taxed at a maximum rate of no more than 25%, and the balance of the gain will be taxed at a maximum rate of no more than 20%. In addition, the taxable gain may be subject to the 3.8% net investment income tax (NIIT). See section 306 for coverage of the 3.8% NIIT.
702.4 The parent may gift the residence to the child. An outright gift will use up part or all of the parent’s federal gift tax exemption and an equal amount of the parent’s separate federal estate tax exemption (in excess of the federal gift tax exclusion). There are no income tax consequences to the parent resulting from the gift. The child will generally take over the parent’s tax basis in the home plus any gift tax paid on the transfer (IRC Sec. 1015). If the child uses the home as a principal residence, any mortgage interest on financing secured by the residence should be deductible as qualified residence interest and the IRC Sec. 121 exclusion may be available on a subsequent sale.
702.5 In Ltr. Rul. 200540008, the IRS addressed the federal tax consequences of a transfer by the married owners of a rental residence burdened by a recourse mortgage to their daughter. In this case, the parents only transferred half of the rental property to their daughter while retaining the other half. The daughter was contractually obligated to pay 50% of the mortgage loan balance to the parents who in turn remained legally obligated to repay the entire loan balance to the lender. The IRS concluded the transfer to the daughter was a bargain sale transaction (as described in paragraph 702.3). For the sale portion of the transaction, the sale proceeds equaled the half of the mortgage loan balance assumed by the daughter. For the gift portion of the transaction, the excess of the FMV of the transferred 50% interest over half of the mortgage loan balance is treated as a gift by the parents to the daughter.
702.6 Depending on the value of the home and the size of the parents’ estates, it may be beneficial for the parents to retain ownership of a home until their deaths. If the home is transferred by bequest, the child receives a basis in the home equal to its FMV on the date of death (or alternate valuation date, if elected). However, retention of the home by the parents means that any appreciation prior to their deaths will be included in their estates and subject to estate tax if the value of their total estate exceeds the federal estate tax exemption at that time.
Example 7-5: Transferred property with retained rights
Alex Jones purchased a condominium. In anticipation of incremental gifts of the property to his children, he executed an agreement that permitted him the exclusive right to use and occupy the property for as long as he desired. Subsequently, Alex transferred legal title in 100% of the property to his children through three deeds. Until his death, he occupied the residence and paid all of its monthly expenses, including utilities, insurance, maintenance costs, taxes, and fees.
The executor of his estate filed the estate tax return, excluding the value of the condo because of the transfers. The IRS asserted, and the Tax Court agreed, that the value of the condo was includable in the gross estate because Alex continued to use and occupy the residence and essentially treated the residence as his own (Tehan).
702.8 To avoid inclusion of transferred property in the taxable estate when the donors anticipate continued use, planners should urge them to follow these steps:
- a. If possible, consider selling the property for FMV based on a qualified appraisal and provide seller financing. (The appreciation on the property will still be removed from the estate.)
- b. Avoid paying expenses of any kind for the transferred property.
- c. Pay the new owners a fair rental payment, documented with terms and conditions that are similar to third-party arrangements.
- d. Document that any physical changes to the property may only be made with the written approval and permission of the new owners.
- e. Consider a qualified personal residence trust (QPRT) (see section 703).
2605. Non-corporate taxpayer’s unrecaptured section 1250 gain taxed at a maximum rate of 25%.
Unrecaptured section 1250 gain, taxed at a maximum rate of 25%, is the excess (if any) of:
- (1) the amount of long-term capital gain (¶ 2601) which is not otherwise treated as ordinary income, and which would be treated as ordinary income if Code Sec. 1250(b)(1) recapture applied to all depreciation (rather than only to depreciation in excess of straight line), and the applicable percentage under Code Sec. 1250(a) (¶ 2696) were 100%, over
- (2) the excess (if any) of the amount of losses taken into account in computing 28% rate gain (¶ 2606) over the amount of gains taken into account in computing 28% rate gain. (Code Sec. 1(h)(6))[ FTC ¶ I-5110.8; USTR ¶ 14.08; Tax Desk ¶ 223,319.2]
The amount in (1), above, from sales exchanges and conversions described in Code Sec. 1231(a)(3)(A) (i.e., section 1231 gain, see ¶ 2684) for any tax year can’t exceed the net section 1231 gain (see ¶ 2685) for that tax year. (Code Sec. 1(h)(6)(B))
RIA observation: Under MACRS, real property must be depreciated using the straight-line method (¶ 1925). Thus, any gain on the sale or exchange of such property that’s attributable to depreciation will be unrecaptured section 1250 gain if held for more than one year.
RIA illustration: Y, an individual, sells nonresidential real property on Aug. 15 for $200,000, realizing a gain of $50,000. This is Y’s only transaction involving a capital asset for the year. Y held the property for more than one year. He depreciated the property using MACRS, and claimed $25,000 of depreciation during his ownership. There is no depreciation recapture under Code Sec. 1250(b)(1) because Y didn’t claim accelerated depreciation. However, $25,000 of Y’s gain, representing depreciation deductions claimed by Y, is unrecaptured section 1250 gain.
For how to handle unrecaptured section 1250 gain where a sale of real property is reported on the installment method, see ¶ 2457. For how unrecaptured section 1250 gain can arise on sale of a partnership interest, see ¶ 3765.
Section 1250 Property
The definition of Section 1250 property is more straightforward than that of Section 1245 property. Section 1250 property is simply any depreciable real property not classified as Section 1245 property [IRC Sec. 1250(c)]. If real property is classified as Section 1245 property at any time during its use, it retains this classification even if its use changes and it no longer meets the definition of Section 1245 property [Reg. 1.1250-1(e)(4)]. Certain Section 1250 property can be reclassified as Section 1245 property if it is converted to use as an integral part of manufacturing.
Treatment of Gain from the Sale of Section 1250 Property
When Section 1250 property is disposed of, any loss recognized is treated as an ordinary (Section 1231) loss. (See Key Issue 6E.) Without a recognized gain, on the sale, there is no IRC Sec. 1250 depreciation recapture to recognize.
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*The opinions expressed in this communication are for general use only and should not be used by the recipient as the basis for the preparation of any tax return, form or schedule. Further, the opinion expressed is based solely on information provided by the recipient and NSA makes no representation whether such opinion may be different if other information had been provided.