Q: I own a house that I plan to gift to my son. The house was purchased in 1993 for $120,000 and today is worth about $380,000. This property has been the principal residence of my wife and I and our son will also use it as his principal residence. My question is whether he will be able to use the tax exclusion for gains if he sells the home later. My concern is that two family members who file separate tax returns would then be claiming to use the same property as their principal residence.
A: The exclusion that you refer to is the ability to exclude as much as $250,000 ($500,000 if married filing jointly) of gain realized from the sale of a property that has been the taxpayer’s principal residence for two of the five years before sale.
Your son will be eligible to claim the exclusion for gains from the sale of a principal residence provided he satisfies all of the requirements. Your prior use of that same property has no impact on his ability to claim the exclusion.
Although it does not change the answer, you never did claim the exclusion for this property. By making a gift you did not have a sale so there was no need for you to exclude any gain. So if your son later sells then he is the only family member claiming the exclusion for this property.
In any event, even if you sold the property to him for $380,000, you could use the exclusion and then he could later use the exclusion again for the same property, provided he meets the requirements.
There are specific exceptions that could create issues for the family. First, if your son assumes a mortgage of yours on this property then you will be deemed to have sold some of the property and gifted the rest. You could use the exclusion for the sale portion (which is based on “proceeds” equal to the mortgage relief).
Second, your son’s tax basis, used to determine a future gain or loss if he sells, will be your tax basis. This would be the $120,000 purchase cost increased by certain closing costs that you paid in 1993 and any capital improvements you made to the property. Any closing costs that he pays to acquire ownership will also add to his tax basis.
This means that if your son is single, he may have already reached the limit of the “single” exclusion ($250,000 is roughly the excess of the current value over your tax basis). If he is married then the exclusion would be $500,000 if he and his wife both occupy the property as a principal residence for two years.
Third, if you ever used the property as a rental or used a portion as a business office, your son may not be able to exclude all of his future gain. If you claimed depreciation for business or investment use, the law requires the prior depreciation to be reported as income when the house is sold. To illustrate I will just assume that this happened, although I recognize it probably did not.
Since you will not sell the house, you will avoid recognizing gain for the prior depreciation. But the gain recognition requirement applies to the property that has had a basis adjustment for depreciation – it does not stick to the specific taxpayer who claimed the depreciation.
Since any depreciation claimed by you would reduce your tax basis, and then also your son’s basis for the gift, he will succeed to the potential gain when the property is sold. This does not apply to someone who bought such a house – their basis is not affected by your prior depreciation.
There is a separate “penalty” if a former rental property is converted to a principal residence and then sold. But this penalty applies to the specific taxpayer who held the property as a rental. Because it does not follow the property your son cannot be affected by this provision.
Your answer is probably very easy — no gain for you so no need to claim the exclusion, and your son can qualify for the exclusion after two years.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.