Tax question: Buying a rental from my parents

[Thehappyvacantlot]

Nine years ago, my parents bought a home (purchase price $200,000) for me and my son to live in (Fort Collins, CO).

They live in PA. I paid them each month with a portion of my payment going toward the principal (basically I paid the mortgage/loan amount each month) with the intent that the home would eventually be mine. Meanwhile, my parents claimed the house on their taxes as a rental, thus depreciating the home. This past February, my parents and I did a quitclaim deed so that it's now in my name. They had depreciated the house down to $155,000 (ish) at the point of turning over ownership to me. I've been maintaining excellent records of everything that has been paid and will eventually have the full $200,000 paid over to them.

My question is this: when I do my taxes online this year and am asked what the purchase price of the home is, is it $155,00 (cost basis) or $200,000? The question is really important also because the value of the home is estimated at more than $500,000 currently. As a single person, I know that I can only claim a tax-free gain of $250,000. I'd like to prepare myself if I will have to pay capital gains.

Also, are there any other tax implications I am missing? My parents' accountant claims that they won't have to pay a gift tax even if they gave me the house.

 

[Taxing Matters]

Unfortunately, you didn't buy the home. At least, that is not what the records will show. Instead, it appears you rented the home and then your parents made a gift to you of it. When you receive a gift, your basis in that gift is the same basis that the donor (your parents) had in the property that was given to you. So, if their basis in it was $155,000 when they gave it to you then that is your starting basis in the home. Your parents will need to file a gift tax return for the gift, though they very likely will have no actual gift tax to pay.

Even if you bought it for $200,000, the basis would not have been $200,000. They'd be selling you an asset worth over $500,000 for only $200,000. The tax law would see that as a part sale, part gift transaction. You'd instead have a basis that is based on a combination of purchase basis and gift basis. Assuming for the sake of my example that the fair market value of the house was $500,000 at the time it was deeded to you, and assuming a purchase price of $200,000 (and the actual purchase price would be different to account for interest) it would work out that 2/5 of the transaction is considered ($200,000/$500,000) the sale. As a result, 2/5 of the $155,000 basis is allocated to the sale transaction, or $62,000. So your parents would have gain on the sale portion of $200,000 - $62,000 = $138,000. You'd get $200,000 of purchase basis out of that. Then the remaining 3/5 of the basis, or $93,000, is allocated to the gift portion of the transaction. So, you'd get $93,000 of basis from that, and when you add the $200,000 from the purchase portion, your total basis would be $293,000. So you get a bigger basis from that but at the cost of your parents paying tax on the $138,000 worth of gain (with potential depreciation recapture) on it now.

The problem is that the facts you gave really don't support that this was a purchase deal. It looks instead as though it was rental for a period of time followed by a gift of the whole property to you, giving you a basis of $155,000.

 

[FlyingRon]

Boy, this one is sticky. I agree with the above. TM, since the depreciated it, how does that recapture affect he parents and the child here?

 

[LdiJ]

Nine years ago, my parents bought a home (purchase price $200,000) for me and my son to live in (Fort Collins, CO).

They live in PA. I paid them each month with a portion of my payment going toward the principal (basically I paid the mortgage/loan amount each month) with the intent that the home would eventually be mine. Meanwhile, my parents claimed the house on their taxes as a rental, thus depreciating the home. This past February, my parents and I did a quitclaim deed so that it's now in my name. They had depreciated the house down to $155,000 (ish) at the point of turning over ownership to me. I've been maintaining excellent records of everything that has been paid and will eventually have the full $200,000 paid over to them.

My question is this: when I do my taxes online this year and am asked what the purchase price of the home is, is it $155,00 (cost basis) or $200,000? The question is really important also because the value of the home is estimated at more than $500,000 currently. As a single person, I know that I can only claim a tax-free gain of $250,000. I'd like to prepare myself if I will have to pay capital gains.

Also, are there any other tax implications I am missing? My parents' accountant claims that they won't have to pay a gift tax even if they gave me the house.

You are buying the house, not selling it, therefore you won't be reporting anything about it on your taxes this year except perhaps the mortgage interest and property taxes that you are basically paying to your parents.. However, you may eventually sell it and since you have been basically buying it on an installment plan, I would consider your basis to be 200k.

I agree that they don't have to file a gift tax return. They are not giving it to you they are selling it to you.

 

[FlyingRon]

Eh? Since the property appears to be worth well in excess of 450,000 (since she was worried that the capital gain exclusion wouldn't cover it), I suspect that the $200,000 (if one were to buy that this was a contract for deed rather than rent) is way below the FMV and not an arms-length transaction. A substantial part is a gift.

 

[Taxing Matters]

I agree that they don't have to file a gift tax return. They are not giving it to you they are selling it to you.

I disagree, as I indicated in my earlier post. From the facts given it appears that the home was a gift — I'm not seeing that there was ever an enforceable contract here for the purchase of the house by the OP. An "understanding" that the OP would eventually get the house doesn't cut it. And certainly the documents involved do not reflect any purchase, making it hard to argue a purchase to the IRS.

Even if it was a purchase, because of the large FMV relative to the purchase price, there is, as I explained, a part sale, part gift transaction here. But the facts as given suggest this is not really what happened.

 

[LdiJ]

I disagree, as I indicated in my earlier post. From the facts given it appears that the home was a gift — I'm not seeing that there was ever an enforceable contract here for the purchase of the house by the OP. An "understanding" that the OP would eventually get the house doesn't cut it. And certainly the documents involved do not reflect any purchase, making it hard to argue a purchase to the IRS.

Even if it was a purchase, because of the large FMV relative to the purchase price, there is, as I explained, a part sale, part gift transaction here. But the facts as given suggest this is not really what happened.

TM, it appears that the property is mortgaged and the OP has been paying the mortgage since day one.

 

[Thehappyvacantlot]

Eh? Since the property appears to be worth well in excess of 450,000 (since she was worried that the capital gain exclusion wouldn't cover it), I suspect that the $200,000 (if one were to buy that this was a contract for deed rather than rent) is way below the FMV and not an arms-length transaction. A substantial part is a gift.

Thank you for your reply. I'm still confused. I understand that I technically did not "buy" a home because it's nothing more than a verbal agreement and quitclaim deed (and years of monthly checks to my father). However, my question: What happens when I sell in, say, two years for a hypothetical price of $525,000? I ask because I want to move (and my parents want me to move). What amount would I be paying capital gains on as a single person who has owned the home for at least two years?

Also, do my parents just complete the gift form or should they expect to pay a gain as well? Please forgive my ignorance! I've tried to research this on my own.

 

[Taxing Matters]

TM, it appears that the property is mortgaged and the OP has been paying the mortgage since day one.

That's not quite right. Specifically the OP stated:

I paid them each month with a portion of my payment going toward the principal (basically I paid the mortgage/loan amount each month) with the intent that the home would eventually be mine.

(Bolding added). The parents owned the house. The parents had the mortgage. The OP paid to the parents an amount that was only a part of the principal. So no, the OP was not paying the mortgage. The OP was paying some amount to the parents less than the mortgage that the parents used to help make their mortgage payments. As there was no enforceable contract to buy the home those payments were rent.

Even if the payments had been exactly what the mortgage payments were and the OP had sent them directly to the lender it would not have changed anything. Imagine a landlord has a lease with a tenant for the rental of a house. The landlord sets the rent amount at the amount of his mortgage on the home and directs the tenant to pay the rent directly to the lender for convenience. Would that make the tenant a buyer of the home? Of course not. It doesn't change that he is a tenant merely because his rent happens to be the amount of the mortgage and he pays it directly to the lender.

I'm still confused. I understand that I technically did not "buy" a home because it's nothing more than a verbal agreement and quitclaim deed (and years of monthly checks to my father). However, my question: What happens when I sell in, say, two years for a hypothetical price of $525,000? I ask because I want to move (and my parents want me to move). What amount would I be paying capital gains on as a single person who has owned the home for at least two years?

Ok, so how this works out is this. In a situation where the home was entirely a gift, you get the same basis in the house your parents had in it. If their basis is $155,000 at the time of the gift, that is your basis in it. After you have both lived in and owned the home for at least 2 years you could sell it and use the capital gain exclusion to reduce your tax on the sale. As a single person, the maximum gain exclusion is $250,000. The sale of the home for $525,000 would mean a gain of $370,000 ($525,000 sales price less $155,000 basis). If you qualify for the full $250,000 gain exclusion, that means the taxable gain is $120,000. The gain is a long term capital gain, which gets taxed at lower rates than ordinary income. How much tax you pay on that depends on your total income. In 2019, if your income is $434,551 or more, the rate would be 20%. That would mean a tax of $24,000. For the sale of an asset worth $525,000 that is a pretty good outcome. If your income is between $39,376 to $434,550, then for a single person the long term capital gains rate is 15%, meaning you pay a tax of $18,000 on the gain.

That's for the federal income tax. There will be Colorado income tax, too, to pay but the Colorado income tax rates are much smaller than the federal rate.

 

[FlyingRon]

Even if this had been a lease-option or even contract for deed, the fact that the amounts paid where less than half the FMV is going to raise red flags that at least part of this wasn't a gift.

 

[xylene]

My parents' accountant...

This is a situation where you need your own tax advisor.

 

[LdiJ]

Even if this had been a lease-option or even contract for deed, the fact that the amounts paid where less than half the FMV is going to raise red flags that at least part of this wasn't a gift.

I was looking at is as a sale from the very beginning...a contract sale at 200,000 from the get go.

 

[Taxing Matters]

I was looking at is as a sale from the very beginning...a contract sale at 200,000 from the get go.

Do you now still see it that way? Even though there was no enforceable contract for the purchase of the property?

 

[LdiJ]

Do you now still see it that way? Even though there was no enforceable contract for the purchase of the property?

Frankly I do. I realize that there is no enforceable contract but this is a very common practice within families. Parents officially buy the property for a young couple, let them make all of the payments for a few years and then eventually deed the property over to them once they are satisfied that they can and will keep the payments current.

 

[Taxing Matters]

Frankly I do. I realize that there is no enforceable contract but this is a very common practice within families. Parents officially buy the property for a young couple, let them make all of the payments for a few years and then eventually deed the property over to them once they are satisfied that they can and will keep the payments current.

That it might be common does not change the character of the transaction. Surely you know that. Without an enforceable contract, the parent can decide at any time to simply not give the property to the child and either sell it, give it to someone else, or whatever. Similarly, the child could stop paying at any time and could not be sued for breach as there was no contract to breach. As a result, the choice to give the property to the child is a gift. It is not compelled by any contract. This is why when clients come to me asking how to transfer property in this kind of situation, I tell them that if they want sale treatment then do it correctly as an arms length deal — sell it at fair market value (FMV), get a proper written contract that reflects the deal, and then actually enforce it if one party breaches it. If you don't do that, the IRS will take the position that the transaction is a gift (or, if it otherwise is a sale but for significantly less than FMV then a part gift, part sale), and in most cases rightfully so. Don't get lead astray by an informal arrangement that might look like a sale in some respects. If there isn't an enforceable contract, there isn't a sale. Here, the parent could have done anything else with the property — sold it, donated it to charity, gave it to a different relative, or whatever — without any liability to the OP. In that case, giving the property to the OP was a gift; the intent was donative since there was nothing compelling the parent to do it.