Individuals looking to pass along their wealth to their children need to be mindful of future tax consequences. Specifically, gifting property directly now as oppose to waiting until death can be a costly mistake and result in higher than necessary future capital gains tax to the recipient. The situation becomes even more complicated when rental property is involved.

Gifting rental property
Gifting rental property can be tricky and is not always the best option from a tax perspective. The donor will be responsible for filing a gift tax return (IRS form 709) if the fair market value of the gift exceeds the $13,000 annual exclusion. The property will need to be appraised properly, but it will likely be below the lifetime gift tax exclusion which is $5.12 million for 2012. The recipient also wouldn’t owe any initial taxes. However when property is gifted, the recipient receives both the property and the property’s initial cost basis including adjustments. In contrast, if the property is inherited, the recipient would likely receive the stepped-up basis which is the fair market value at the time of death. For instance, if the donor initially purchased the property for $100,000 and gifted it to the recipient now, the recipient’s basis would be $100,000. If it is inherited property, the recipient’s basis would be the fair market value at the time of death or what could be $225,000. The higher the cost basis, the less capital gains taxes the recipient would have to pay when they eventually sell it.

Can I claim the capital gains exclusion when I sell it?
The recipient may be able to utilize IRC Section 121 to claim a portion of the capital gains exclusion. Please note that any depreciation taken while the property was a rental will not qualify for the capital gains exclusion, and will instead be subject to depreciation recapture. In addition, the amount of the capital gains exclusion is generally allocated on a pro-rata basis in accordance with how long the property was considered qualified versus non-qualified. Renting the property is considered non-qualified use. So, if you own a property for 10 years and its a rental for 5 out of the 10 years, you may be eligible to exclude 5/10 of the exclusion. However, subject to certain exceptions, non-qualified use prior to January 1, 2009 will be ignored for purposes of Section 121. In a nutshell, this means that you inherit your the donor’s non-qualified use of the property as well which would limit your capital gains exclusion.

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