Unfortunately, when you own an appreciated asset you will be faced either with a gift tax or an income tax on a subsequent transfer to another individual(s). I assume for purposes of this discussion that your daughter has paid the property taxes and mortgage payment, if any, and that you have not charged rent. Also, I assume you are the only person on the mortgage.
Gift Tax Basics
First, you may gift up to $11,000 per person, per year free of any gift tax liability or gift tax filing requirement. You also, as indicated by one of the other specialists, may gift up to $1,000,000 (this applies to gifts in excess of the annual $11,000 exclusion) during your lifetime before you actually have to begin writing checks to the IRS.
Income Tax Basics/Capital Gains
From an income tax perspective, your gain/(loss) is figured as the difference between the net sales price and your cost basis in the property. Your net sales price is equal to the contract sales price less selling expenses and any fix-up expenses incurred within 90 days of the sale. Your cost basis is your original acquisition cost (including non-recurring closing costs) plus improvements less any allowed or allowable depreciation. Your first step in mitigating gain on sale is making sure you have an accurate cost basis.
If you own the property for more then one year, then the gain will be treated as a long-term capital gain taxed up to a maximum capital gain rate of 15% (5% if the gain would otherwise be taxable in the 10% and 15% brackets). Otherwise the gain is treated as a short-term capital gain and to the extent not offset by other capital losses will be considered as ordinary income the same as wages and interest subject to whatever your marginal tax rate is.
For state tax purposes, AZ would require that you file a tax return and pay income taxes on any gain realized on the sale of AZ property. CA would also tax the gain on the sale of the property by virtue or your residency status. However, you would receive a tax credit on your Form 540 to the extent of AZ taxes paid, thus you will only pay one state tax.
First, if you are the only person on the title and mortgage note, only you are entitled to take the available tax deductions for property taxes and mortgage interest expense (subject to the $1,100,000 mortgage limit on two properties). To the extent your daughter has been paying this, she (and her husband) has been making a gift to you of those payments. To the extent those payments exceed $11,000 per person, they may have a gift tax return filing requirement.
However, you could mitigate this by reporting the property as a rental (i.e. Schedule E) and charge a fair market value (FMV) rent. To the extent the FMV rent is in excess of the actual payments, you may consider it a gift subject to the $11,000 annual exclusion. In addition to the rent you may then deduct all the other costs associated with owning the property including depreciation.
If instead you have been making these payments all along, then there is no problem, except if you did not charge rent; the IRS may consider that to be a gift. This type of issue has generally never been a focus for the IRS however; it is a risk factor you should be aware of.
If you have charged a FMV rent to your daughter and reported it in full on your tax return for at least one year, I believe that would stand a reasonable chance of success in establishing the property as an investment property in the event of an audit.
As an investment property you may defer recognition of gain by completing an IRC Sec. 1031 like-kind exchange into another property. There are specific rules to follow to accomplish this non-recognition including meeting certain time limits with respect to identifying and completing the transactions (i.e. the sale and replacement purchase) as well as making sure the replacement property is of equal or greater value and carries at least the same amount of mortgage debt. Finally, to successfully defer recognition you must not actually or constructively receive any "boot" (i.e. cash or other non like-kind property). A competent tax attorney or escrow officer could refer you to an exchange specialist who could advise you on the rules for an exchange and on how to structure your transaction.
What I have in mind is that you would convert property into an investment property. Complete a 1031 exchange into a property your daughter would like to own (remember, the FMV of the replacement property must be equal to or more then the property sold). You would then subsequently rent it again to her for full FMV rent for at least one year. Then you could either sell it to her or begin an intervivos (i.e. lifetime) gifting process to transfer the property to her.
Option 1 - Sale of the Property
A sale could be done traditionally with third party financing, completely paying you off for full market value. Of course you would have the tax consequences enumerated above, however, your daughter and her family would own the property. You could then gift and/or loan them the money need to make a down payment on the new house. Any loan could be subsequently forgiven in $11,000 per person annual installments.
Alternatively, you could sell the property to your daughter for less the FMV, treating the transaction as part sale, part gift. You would thus have both a gift tax return filing requirement (probably using up some of your lifetime exemption) as well as an income tax consequence. Completing such a transaction is like splitting the baby, reducing the gift and income tax impact relative to a complete gift or sale.
Another option would be to sell the property to your daughter (and husband) and take back an installment note for 100% of the sales price. The note should be recorded and secured by the property, both to protect your interest and to allow them to deduct the interest as mortgage interest. There would be no immediate gift tax consequence (unless you sold for less then FMV) and you would only recognize gain as your daughter pays you principal on the installment note. You could then begin gifting the note to your daughter (and her husband) to the tune of $11,000 per person, per year with no gift tax consequences. Please note that to the extent your daughter (and husband) receives the property as a gift, they will take over your cost basis and holding period for income tax purposes. Also, if they subsequently sell the property before the installment note is paid off, you will be required to recognize the remaining gain in full, so make sure they pay you the remaining note.
Option 2 - Gift Transfer Techniques
There are several other techniques that you can use to transfer the property to your child at a reduced gift tax cost. Complexity and cost to implement varies and should be taken into account when deciding which strategy to pursue. Such strategies include formation of Family Limited Partnerships and gifting interests to the child, private annuities, self-canceling installment notes, intentionally defective grantor trusts, grantor retained annuity trusts and shared equity arrangements. All of these strategies involve multiple issues including gifts, sales, valuation discounts, etc. All would require you retain competent professional help to implement. Thus, the tax savings of such strategies need to be significant to justify the cost.
Option 3 - Retain the Property
Another option is to retain the property yourself and convert it into a traditional rental by renting it out to a third party. Have your children manage it and pay them a management fee. The tax consequences (and cash flow) are yours. You could begin gifting ownership interests in the property to your daughter at that point via one or more of the methods I described above. The advantages of transferring the property during your lifetime include shifting the ongoing tax burden as well as moving future appreciation out of your estate. The downside is that since the transferees assume your cost basis (instead of receiving a stepped-up cost basis to date of death FMV) they will ultimately have a greater tax burden when they sell.
Estate Tax Issues
Currently, estate tax law is in a state of flux. Estates of individuals who pass away are required to file an estate tax return if the gross value of the decedents assets (plus taxable gifts in excess of the $11,000 annual exclusion made within three years of death) is in excess of $1,500,000 ($2,000,000 for decedents who pass away in 2006). Eventually in 2010 the estate tax disappears only to reappear in 2011 in its tax year 2001 form. When an individual dies his heirs generally receive a step-up in basis on all assets inherited to their date of death fair market value. Thus, heirs are only taxed on post-death appreciation. This step-up however, does not apply to items classified as "income in respect of a decedent" (IRD). IRD generally consists on items that would have been taxable income in the hands of the decedent and include IRA and pension accounts, U.S. Savings bonds, final salary, etc. Such items are subject to special provisions and are taxable to the recipient heir.
I strongly recommend that if he unrealized gain on the AZ property is significant, that you see a qualified estate planning attorney who can perform a better review of your options then can be done here. My purpose was to give you an idea of the possibilities and to help you address some of your current taxation issues.
Please do not hesitate to ask additional questions. I will be happy to answer until you are satisfied.