Minimize Tax Implication of Rental Property
My husband and I have fully depreciated a rental property that we own (no mortgage). We'd like to sell the property but my husband says our net profit will be small based on it being fully depreciated. If I Quitclaim the property to our 16 year old son, do we avoid further taxation? When our son sells the property, wouldn't he pay income tax based on his tax bracket? <IMG SRC="images/forum/smilies/icon_rolleyes.gif"> [ Edited by alexaadams on Date 04/06/2003 ]
When did you buy this property, how much did you pay for it, and how much will you get when it is sold?
You said the property is fully depreciated, so I will assume for now that you purchased this property about 20 years ago. For the sake of illustration, let's also say that you paid $35000 for this property. If the property experienced a normal rate of appreciation over the past 20 years, then I will guess that this $35K property will sell for $140000 today.
Let's also say that the land value when you purchased this property was $9K and the depreciation basis for the improvements was $26K.
If your property is fully depreciated, then your cost basis is the land value -- $9K. If you sell this property for $140K, you will have a $131K taxable profit. Of this amount, $26K will be depreciation recapture and taxed at 25%. The balance of your profit, $105K will carry a maximum capital gain tax rate of 20%. Your potential tax liability on the sale of this property is about $27500.
After paying the federal taxes, you will have $103,500 left in your pocket (before you pay state taxes, if any). Your tax liability on the sale of this property works out to a (blended) rate of just under 21%. If you gave the property to your son and then he immediately sold the property, I would venture to guess that his tax liability would be higher. I say this because (unless your holding period can be tacked on to his) his holding period will not be long enough to qualify for the long term capital gains tax rate. In this case, his profit on the sale of the property will be taxed at his ordinary income tax rate. What is the tax bracket for $131K of income?
I hope with this illustration that you realize that it will be worth your time and effort to compute the tax liability on the sale of your property before giving away all your equity just to avoid a tax bill.
If the cash flow on this property is pretty good, why do you want to sell? If it is to acquire another rental property, consider using a tax deferred exchange to sell your rental property and replace it with another rental property -- potentially deferring capital gains taxes indefinitely.
The foregoing is my lay opinion. Consult your tax advisor for specific details.
A few additions to Dave T's comments:
attorney and tax advisor, as there are some pretty big taxes that can result here. Your EP attorney can show you how to use a LLC to get discounts on the value of the gift and still control the funds from the sale of the property.
First, if you gift the property to your son, your son will take the same basis that you had in the property (i.e. $0).
Second, since this was a gift, the holding period that you held the property will tack to your son. This means when you son sells the property, he will have been deemed to own the property for more than 1 year even if he sells it immediately after it is gifted to him.
Third, you have to watch out for gift taxes here. A person can gift no more than $11,000 of property to a person a year tax-free. If you gift more than that amount, you might escape gift taxes (starting at rates of 35% and going up to 50%) if you use part of your unified credit. Basically you have about $650,000 of unified credit. If you use part of the unified credit, you should file a gift tax return so that the IRS does not tax the gift. The gift is imposed on the donor (you), not your son and it is a tax that is different than the income tax (which your son would recognize on the sale of hte property). Some people with large estates should watch out about using their unified credit because if you use all of it up, then at your death all of your assets will be subject to estate tax (at rates from 35% to 50% assuming Congress does not make the estate tax repeal permanent -- it is due to expire in 2009).
On top of that, if you do make the gift to your son and he sells the property and gives you the proceeds, your son could be hit with gift taxes.
Before venturing on this issue, talk with your estate planning ("EP"
Hope that helps,
Taxjunkie