USA Selling Rental House to Family

[mibaile5]

I have some questions regarding the tax laws in selling a rental property to family. I have a property that my sister and her family have been renting from me for several years. We lived in this house as our primary residence for several months, prior to deciding it wasn’t a good fit and we needed something larger. They would like to purchase the property, we are not using a realtor (which helps $ a lot). They have already been approved by a lender and sent me an offer, which is market value of the house (23k more then we paid for the house in 2017). However, they are having the lender build in their closing costs (12k) and are also asking for “gift equity” of 15k so they can put it toward their down payment. After deducting those, we are actually receiving 3k less than what we paid for the house, which I’m ok with. I am wondering if there are any tax implications from the gift equity in 2022? I have heard there are tax implications to selling a rental property to a family member, such as not being able to claim depreciation/PAL? Since the rental house is selling for 23k more then we paid, I assume we would have to pay capital gains on this but would the closing or gift equity be deducted from this amount first (which would make it $0 profit). We are worried our 2022 taxes will get hit from this transaction. Thank you.

 

[BIG E]

I strongly suggest you consult with a licensed tax professional because you have raised a number of tax issues simultaneously.
The first of which is your being able to claim part of the $ 250,000 gain exclusion from the sale of primary residence where you had to have owned and lived in the house 2 out of the last 5 tax years. Otherwise you need to report the gain as taxable income.
Second, is the gift tax filing. Under whose name is the property currently titled - you, you and your spouse, or your spouse only? Annually you can gift up to a maximum of $ 15,000 per person without having to file a gift tax return that shows your excess in a given year. Excess reduces your lifetime estate and gift tax exclusion.
Third, what evidence do you have that the FMV you're selling for is actually a true FMV? Have you had the property appraised by a licensed independent real estate appraiser?
The gifting of the money to reduce their cash cost - doesn't have an effect on the sales price or profit/loss - it merely reduces the amount that's due you at closing.
Don't forget that if you have been treating this rental property properly - you should have been deducting depreciation for the period it was rented (assuming that you received FMV rent). That depreciation reduces your cost basis for determination of gain/loss.
Other issues that come up are any passive loss carryovers taken during the rental period.
So you have a number of considerations to think about - that's why it's important that you speak to a licensed tax professional before making any decision to sell the property.

 

[MoralesTax]

I think @BIG E nailed the response. I would add that you first should determine whether the sale will generate a gain or a loss, before anything. Since this is a related-party transaction, you won't be able to recognize a loss on the sale. Given that you should have "several year's" worth of depreciation, you'll likely have a gain. Regardless, this issue certainly needs to be addressed first. Without knowing your cost basis in the property, it is impossible for anyone of us to do this calculation for you. We would need access to your 2019 tax return.

Secondly, you need to determine if the $250,000 gain exclusion for primary residence applies to this property. If you lived in it for 2 out of the last 5 years, and you haven't taken this gain exclusion within a certain time frame, then the gain exclusion applies to the extent of the gain that is not depreciation recapture from the rental activity.

Third, the gift equity is a non-factor. Since it is $15,000 gift, it does not have a filing requirement. The lender merely will wish you write a letter certifying that you are indeed gifting the amount and not loaning it. However, if that amount were greater than $15,000, you would have a Form 709 filing requirement.

Last, passive activity losses could be a factor at play here too. Without further details from the 2019 tax return, it's impossible to advise any further on this portion of consideration.

 

[mibaile5]

Thank you both for the quick replies.

The sale Price of the house is similar to other houses in the neighborhood that have sold and I also had a realtor do comps.

We did not live in the house for 2 years so the capital gains exclusion does not apply.

For the 15k in gift equity, I know you can gift up to that amount per individual (there are 2 of us on title).

I guess my main question is, can you still “count or use” depreciation to adjust the cost basis if you sell a rental property to related family? We have been deducting depreciation and we do have PAL carryover.

We paid 340k for the house in 2017. At the sales price of 363k, at most we are looking at gains of only 23k. However, they want to receive the 12k in closing costs and 15k in gift equity, it actually comes in at 337k (lower then what we paid for the house). Can I also deduct the closing costs from the 23k profit lowering the capital gains amount I can be taxed on?

I apologize if this is confusing.

 

[BIG E]

I still think you don't understand how the calculation works.
I don't know how much depreciation was taken - but for illustration assume $ 20,000.

In order to determine gain you must first reduce the cost basis by the depreciation previously taken as a deduction.
So the calculation works like this
Initial Cost basis $ 340,000
Depreciation Taken - 20,000
Closing Costs + 12,000
Cost basis of House $ 332,000
Sales Price of House 363,000
This leaves you with a profit on sale of $ 31,000

The $ 15,000 gift you are giving them only reduces the net proceeds you are paid at time of settlement
It has nothing to do with the gain on the property.
Since you have reported this property as investment property - you have to report the sale on Form 4797, treating the building from the land as two separate transactions and allocating the sales price and closing costs in proportion to their assigned values. Land on P. 1 as long term, and the building on P. 2 reporting the cost and the depreciation claimed.

 

[mibaile5]

Thank you, you are correct I confused PAL and depreciation.

My understanding is that we cannot claim PAL if the transaction is with a related party? Is that correct? Does it make more sense to lose any PAL (~20k) because it’s a related party transaction or to just go ahead and not sell to family and instead sell it to an unrelated party (using realtor, purchase price should be similar but no gift equity, etc). Hope that makes sense.

Thanks again, you have been extremely helpful.

 

[BIG E]

You seem to be hung up on related party issues here.
So long as FMV is used in valuations of exchanges, there is no issue.
The only time that "related party" becomes an issue is when it involves losses on transactions or deep bargain exchanges of investment transactions. Here you are declaring FMV for price of property sale, and in addition - have a taxable gain. There is only one situation other than that I can think of where related party issues arise - installment sales.
Once you have reported a disposition of a Passive Activity Loss type investment, the passive activity losses are deductible against the rental activity of the property as that's where they originated.

 

[mibaile5]

Understood. Yes, we are stuck on the related party piece. We read this in the IRS pub, see the sentence above the caution picture. Maybe we are misinterpreting it?

 

[BIG E]

To my surprise - yes - that apparently IS true. I wasn't aware of it.
However - you don't lose those passive activity losses forever. You are able to claim the PALs only when the related person disposes of the activity in a taxable transaction with an unrelated person. However - your situation is different. You are not selling it to someone who will be using it as a passive activity. They will be using it as a personal residence.
If the person you are selling to will be using it as a passive activity investment, you don't lose those passive activity losses forever. You are able to claim the PALs only when the related person disposes of the activity in a taxable transaction with an unrelated person.