121 exclusion on gifted property - conversion from primary residence rental

[tcpa03]

Can you help with this question?

Family lives in rental property for primary residence (greater than 2 years).

Rental property gifted to family in current year.

Family (new owners) sell the home a few months after gifting takes place.

For capital gains treatment, they will get long term treatment since the property was held by the original owner (giftor) longer than 1 year.  

Question - can they count the years they lived in the house (prior to ownership/gifting) to meet the ownership/primary residence test for the 121 exclusion?  

[BobKamman]

Short answer:  No.

Long answer:  Why do you assume they get Daddy's basis and holding period?  That's likely, but we don't know if FMV at time of gift was less.  Then there's the problem with tax rate on recaptured depreciation.  And did they actually get to keep the proceeds?  They weren't reinvested in a place that also has Daddy's name on the deed?  IRS would look at substance over form. 

[qbteachmt]

Here's what I don't understand: you seem to want to claim Both that there is satisfaction of the "2 out of 5 years" residence test and also there is the "more than 1 year ownership" rental test. Yet, neither applies. And they are conflicting.

These people were tenants in a home they did not own for your "2 of 5 years" test.

These people never owned a Rental. They lived in the property. That's why the "more than 1 year" test doesn't apply.

Why not start with the basics: have you got the info as to the FMV at the time of transfer? Have you confirmed this "gift" really happened with all legal requirements? Have you confirmed the gifted amount per family member falls in the Gift limit?

And all of that is why the prior ownership doesn't carry over to the new owners for purposes of your question.

There are not enough details here, really.

[Accountant-Man]

I hope I get this right: tenants of the house lived in it more than 2 years, but rented it from a family member.

FM gifted it to them, and they sold it within less than a year.

FM's basis was gifted to them, and if it was a fair market value rental, the adjusted basis of the property was transferred to them, meaning less depreciation. The gift was the FMV at the transfer date. Was a 709 prepared?

The holding period doesn't transfer, so the sales price less FM's basis is the gain, short term. 

They did not live in it as owners long enough to use Sec. 121.

I hope you are not their tax advisor,  because they could have a large ordinary gain.

[BobKamman]

See IRS Pub 544:  

Gift. 

If you receive a gift of property and your basis in it is figured using the donor's basis, your holding period includes the donor's holding period.

[qbteachmt]

But isn't this a worse situation? Now they have to consider rental income and depreciation. And does this convert their occupancy years from tenant to owner?

Why does no one get advice before trying these things?

[BobKamman]

I think they probably did get advice before the deal and figured that Daddy would have to pay 25% on the depreciation recapture, but kids might be in a lower tax bracket for much of it, or might get away with ignoring it.   I'm not certain that the depreciation recapture carries over from the gift-giver, but that question hasn't been asked yet.  Had the place been refinanced?  What are the rules on gifts of appreciated property with a mortgage?  I know for charitable donations it can be an issue, but haven't come across it in a family situation.  

[tcpa03]

The FMV at the time of the gift is greater than the basis of the giftor.  Thus, they will get the carryover basis from the giftor but will have to factor in any additions (substantial improvements done by the giftor since the home was purchased) and subtractions (any depreciation taken when the property was a rental).  Depreciation will be passed on to the family receiving the gift.  

[tcpa03]

The rental income would have been taxed on the giftor's return throughout the years and the recipient wouldn't have to recognize that income.  They do have to reduce the basis of the house by any depreciation taken.

[tcpa03]

They get the giftor's adjusted basis in the property along with the giftor's holding period.  In this case, the mortgage has been paid off and the property is free and clear of any debt.

[rbynaker]

I think they "step into the shoes" of the giftor.  The adjusted basis should be reported on the giftor's Form 709, but you might not have access to that.  If there were suspended PALs, I think they also get added to basis so that may be something else you want to look into.  Sounds like they do get the extended holding period but I'm fairly confident that does not constitute ownership for the purposes of Section 121.  The depreciation will be recaptured and taxed at ordinary rates not to exceed 25%.  If there's gain above that you might look at the provisions for a limited exclusion to see if they have a Darn Good Reason(TM) for selling with less than two years of ownership (change of employment, medical or "unforeseen circumstances" listed in the regs).

If you do qualify for a limited exclusion, I'm curious (and do not know) how the extended holding period might affect the determination of non-qualified use for Section 121.  I *think* the non-qualified use ties back to the ownership rather than the extended holding period (so by definition, no NQ use) but it's worth spending some time researching the Regs to make sure receiving the property as a gift does not bring with it also stepping into the NQ use period.

Rick