Tax Aspects of Selling a Gifted Home
Being gifted a house brings more than just gratitude. Subsequent treatment of the property and related tax considerations should be top of mind as well. What is done with the home matters, especially when it comes time to sell. Tax consequences at that time depend on a few things, largely including basis in the property.
Basis is what offsets the sale price that results in either a gain or loss. Normally, when an asset is sold, it was purchased before that by the seller and therefore the cost is its initial basis. But with a gift, there was no cash outlay by the recipient - that’s the point! So, where do we go from here?
When a home is received as a gift, the donee generally receives “carryover basis” in the property. In other words, the adjusted basis of the donor becomes the adjusted basis of the recipient. However, there are a couple exceptions.
The first exception is if the recipient decides to sell the property and the donor’s adjusted basis in the property was more than its fair market value (FMV) at the time of the gift. If using the adjusted basis results in a loss on sale, the recipient must instead use FMV at the time of gift as basis in the property.
Charlie gifts Sam a house with FMV of $250,000 as of the date of the gift. Charlie bought high and has an adjusted basis in the property of $300,000. Sam decides to sell the house a little while later to access the cash value. Sam was able to sell the property for $240,000, which would result in a $60,000 loss if Sam used Charlie’s adjusted basis. Because of this computed loss, Sam must instead use the lower $250,000 as his basis, which was the FMV at the time of the gift, resulting in a $10,000 loss for Sam. The tax effect of this loss will depend on how Sam treats the gifted property.
If instead a gain is calculated upon sale, then carryover basis from the donor is the basis to use.
Assume instead Sam was able to sell the property gifted to him for $310,000. Sam will use Charlie’s adjusted basis in the property of $300,000, resulting in a $10,000 gain.
The second exception is if the donor paid gift tax on gifting the home and at the time of the gift, the donor’s adjusted basis in the property was less than FMV. In this case, the recipient will use the donor’s adjusted basis as his/her own but also add in the Federal gift tax paid by the donor due to the increase in value of the home. Reg. section 1.1015-5 provides detail on this calculation.
In any case, the recipient will make any required adjustments of their own to basis while they held the property, such as repairs, improvements, and selling costs. Also, know that receiving property as a gift during the donor’s lifetime isn’t the same as inheriting it upon their death; the two situations have different rules for tax purposes.
How’s a Sale Taxed?
Receipt of the gift is not considered income to the donee, however, selling the property may bring tax consequences. How the property is treated after the gift can bring a range of outcomes.
Living in the property before selling it is a good option. IRC §121 allows a potential exclusion for up to $250,000 ($500,000 for those MFJ) of the gain on sale of a home if it was used as a primary residence for at least 2 of the last 5 years prior to the sale. Any gain outside of the exclusion is considered a capital gain but unfortunately a loss on the sale of a personal residence is considered a nondeductible personal expense. Holding the property as a second home is also a possibility, with a gain on sale resulting in capital gain but again, no available tax loss for personal capital assets such as this one.
If living in the gifted property isn't an option or desired, consider renting it out and then making an IRC §1031 like-kind-exchange to defer tax on sale. This is a powerful tool that many investors use repeatedly, building net worth while deferring, or potentially avoiding a tax bill if deferrals continue until the owner’s death. Sale of a rental property will bring a different tax treatment in that there may be ordinary depreciation recapture on a gain, with the remaining gain taxed as capital. The good news is unlike personal capital assets, a loss on sale of a rental property will be deductible.
In determining whether a gain is long term or short term, the recipient of the gifted property takes the donor’s holding period. This is important because short term gains for property held less than one year are taxed at ordinary rates vs more favorable long-term capital gains rates for property held longer than one year.
Finally, consider donating the property to a charity instead of putting it up for sale. Make sure the deduction can be utilized within 5 years, as there are limitations of how much charitable giving a taxpayer can use each year.
Whatever happens with the property, keeping good documentation of the gift will be essential to substantiate its basis. Make sure to record the date of the sale, property details, any federal gift tax paid on the gift, and donor adjusted basis and FMV at the time of the gift. It’s recommended to obtain the donor’s original purchase documents and any receipts for adjustments that increased basis along the way before the gift.
Not having this information can potentially result in no available basis to claim and unintentional “gifts” to the IRS in the form of tax due.