"My question is: Did he make a terrible financial mistake by giving me this condo instead of leaving it to me in his will? I have been told that if I sell, which is likely in about 2 yrs., that I will have to pay thousands in capital gains tax, whereas if I had inherited it, I would not have. I have two sons who will inherit everything I have. Now, should I 'sell' condo back to my dad to avoid the taxes should I sell it. Then, if I decided he needed to sell it in next year or so, would he pay taxes only on the difference of the present day value ($550,000) and whatever he got above that amount?"
"But, if I sell it back to him, to avoid the capital gains taxes, and I inherited it when he passes, THEN I sold it, what amount would I pay taxes on??? I need to know what to do in order to pay the least amount of taxes to Uncle Sam. When I mentioned to my accountant that my dad had just given me the condo, he said, "you know that was a big mistake, tax wise." What are the repercussions - tax wise - of all my options??? Thank you very much."
Giving the gift of real estate, while immensely generous, often comes with several disadvantages from a tax perspective. Some tax professionals advise people never to give real estate. I think that sounds a little too harsh, because I can imagine scenarios where giving real estate can be a smart tax move. However, this is not one of those situations.
Capital gains on gifts vs. inheritances
In general, you should prefer inheritances rather than gifts of real estate. Here's why. At death, the executor of your father's estate will value all the property in the estate. The executor will also value all the property again six months after the date of death. The executor will then choose whichever valuation date results in the least possible tax consequences. As an heir, your cost basis in the property will be the fair market value on the chosen valuation date. This is called "stepped-up basis," and generally provides an excellent way to minimize your taxes when you later sell the property.
In a gift situation, the recipient's cost basis is the same as the donor's cost basis. This makes gifting a slightly less favorable way of transferring assets. However, gifting can be an excellent strategy for shifting capital gains to family members with lower tax rates. For example, let's say you are sitting on long-term capital gains on some stocks, and those gains would be taxed at 15%. You can gift those stocks to another family member with little or no income, and the gains could be taxed at the lower 5% rate. The taxable amount of the gain is the same in either situation, so gifting is simply a way of choosing a more favorable tax rate on appreciated investments.
Capital gains on rental property
With regard to the rental property, your cost basis in the gifted property is the same as your father's cost basis. So if your dad purchased the property for $65,000, that's your cost basis as well. You'll need to carefully review your "adjusted cost basis" in the property (I provide the formula in my article on Reporting Rental Income on Schedule E.) In particular, you reduce your cost basis by the amount of depreciation you and your father claimed, or could have claimed, as a deduction. This will decrease your cost basis even further. Furthermore, the gains on the rental property will be taxed at two different tax rates: ordinary income tax rates on the amount of the gain attributed to depreciation, and long-term capital gains tax rates on any gain leftover after depreciation has been accounted for. This is called "depreciation recapture," as was the topic of a previous tax question of the day.
What to do now
What you should do now depends entirely on how long you plan to keep the rental property. If you are going to keep the property for the rest of your life and pass it on to your children as an inheritance, then there's really nothing you need to do right now. However, you indicated you might want to sell the property in the next few years. Someone will have to pay the tax on the gains, either your father or you or someone else. You should sit down with a tax professional and plan out the tax consequences of various strategies, and find out which strategy will save the least amount of tax.
Your possibilities include:
- Undo the gift. Not sure if this can be undone after so many years have passed since the original gift.
- Give the property back to the father. His cost basis will be the same as your cost basis, which is to say that it is your father's original cost basis, as adjusted for depreciation and other factors. Your father could then sell the property, or hold it until he dies.
- Give the property to someone else. Perhaps your children or other relatives. The idea here to choose the tax rate with the most favorable tax consequences.
- Give the property to charity, and let them take all the gains tax-free.