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Christopher Phelps
Christopher Phelps, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 2710
Experience:  CPA, CFP, PFS, Tax Practitioner 21 Years, Member AICPA/CSCPA Tax/Financial Planning Committee Member
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tax treatment of residence if converted to rental property

Customer Question

My sister and I were added to the deed on my elderly mother's house last year. Can we avoid capital gains on this property that my mother has lived in for over 50 years?? Is it possible to rent the property for a short period of time and then sell it and have the proceeds rolled over to another property without paying the capital gains from my mother's house?
Submitted: 11 years ago.
Category: Tax
Expert:  Christopher Phelps replied 11 years ago.

Technically, when you were added to the deed your Mother made a taxable gift to you and your sister.  More then likely your Mother needs to file a gift tax return.  She propably will not have to pay anything but she will use up some of her lifetime $1,000,000 gift exemption.


Your cost basis in the property is equivalent to whatever your Mother's cost basis is.  Your holding period is also the same as hers.  Thus, when you sell it will be as if she sold it and you will have to recognize gain just as she would have.  Unfortunately, you may not be able to claim the Sec. 121 exclusion ($250,000 if filing single or $500,000 if filing MFJ) unless as of the date of sale you owned and used the property as your principal residence for two out of five years.  Thus, you will owe capital gains tax (max of 15% Federal) on all the gain.


If you subsequently turn it into a rental you will only be able to use your Mother's cost basis to determine your available depreciation (assuming the FMV is in excess of her cost basis).   After a period of time as a rental you may be able to do a 1031 exchange into another rental property (or other real estate investment) without having to recognize gain if you comply with the provisions of the code.


I generally recommend not putting children on the title of the parents house for the obvious reasons stated above (lousy tax ramifications).  It is generally better for you to inherit the home so you will receive a step-up in the cost basis to its fair market value as of the date of death of the last parent owner.  That way you avoid paying capital gain tax on the appreciation obtained during the life of your parents.  If not to much time has elapsed you should deed your interests back to your Mother and handle succession to ownership of the property through a living trust.  Also, have her prepare powers of attorney so you can make legal decisions for her should she become incapacitated.

     
Customer: replied 11 years ago.
Reply to Christopher Phelps's Post: Can you give me some idea as to the provisions of the 1031 exchange..how long does the property have to be rented before it can be sold and the proceeds exchanged into another real estate investment? Are there other exacting stipulations to this exchange?
Expert:  Christopher Phelps replied 11 years ago.

Rental periods are a judgment call.  But generaly case law supports six months to a year is sufficient to establish investment intent.  Thus, I would rent the current property for at least 6 months and the property you exchange into I would rent a year before you sell or convert to a principal residence.


Remember, to do a 1031 exchange you need to use an accomodator and you must never touch the cash.  Any monies you receive or constructively receive will be deemed realized gains reportable for tax purposes.  Also, you must make sure that mortgage debt on the new property is at least equivalent to what was on the old property.  You generally have 45 days after the sale of the old property to identify potential new properties, and you have to complete the transaction within 180 days. 


Most escrow companies can function as an accomodator or will point you to a qualified accomodator. 

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