Hamill: Should dad gift the house now or leave it in his will?

Question: I am 28 years old and have been married for two years. My husband and I are planning to start a family. It is so hard for a young couple to afford a house these days, but my father has offered to give us a house that he has rented for the past 15 years. I am very excited about this idea, but one of my father’s friends told him it is best for tax purposes to leave the property to me through his will. This would allow me to sell and avoid any tax. My father is now wavering about making the gift because he thinks the family will benefit more if I inherit and avoid paying the government any tax. A friend of mine who is a financial planner told me that if I plan to make this home my principal residence, I would be able to sell the home after living in it for at least two years and avoid any tax. If my friend is right (we plan to live in the home for a long time), then I think I can convince my father to give me the house now.

Answer: Well, your friend is mostly right. But he is right enough that I don’t see any significant tax reason to delay making the gift.

When someone inherits property, the tax basis is adjusted to the fair market value of the property at the date of death.

As a simple example, let’s say that your father purchased the house for $250,000 and claimed $100,000 of depreciation deductions in the 15-year rental period.

His adjusted tax basis is then $150,000 ($250,000 cost minus $100,000 depreciation).

Tax basis is important because a gain on sale is reported only if the sales price exceeds that basis.

If the house is now worth $450,000, a sale by your father will cause him to report a $300,000 gain ($450,000 minus $150,000).

When appreciated property is received as a gift, the tax basis is the same as it was to the person who made the gift.

If you immediately sold the house for $450,000, it would then be you who reported the $300,000 tax gain.

This is like “The Cat in the Hat Comes Back,” where a spot moves from place to place but doesn’t seem to go away. In that tale, the problem was solved when Little Cat Z arrived and made the spot disappear with “Voom.”

Your friend suggests that living in the home for two or more years after the gift can be your Voom. Section 121 of the tax law indeed allows a married couple to sell a home and exclude as much as $500,000 of gain from tax.

So, if you later sell this home for, say $600,000 — assuming it continues to go up in value — your gain would be $450,000 ($600,000 minus $150,000 basis).

Section 121 would appear to allow you to exclude this entire gain. The problem would be the depreciation your father claimed.

Section 121 penalizes “nonqualified use,” which is use for a business purpose before the residential use.

Your father had nonqualified use. If you immediately use the house as your principal residence after the gift, you will have no nonqualified use.

But another penalty in Section 121 requires a seller to report any depreciation adjustments as income when the house is sold.

You do not plan to claim any depreciation — that is not allowed when the house is used only for personal use. But “depreciation adjustments” means any depreciation, claimed by anyone, if the depreciation affects the seller’s tax basis.

Because your tax basis will be the same as your father’s, his depreciation will cause you to report a gain when you later sell the house.

This is so even if you use the property only as a principal residence. Using my numbers from above, you would report a gain of $100,000.

If the house is inherited, the basis becomes fair value and the potential penalty for depreciation adjustments goes away. Voom.

I don’t know how much depreciation your father has claimed. If he makes the gift, you will need to know. You will also need to know his tax basis.

But I do not think this potential tax penalty is a sufficient reason to delay the gift. But it’s your father’s call. With the right information.