I have a rental property that I paid $100,000 for, and I am going to sell it to my daughter for the same amount. I’ll finance the property for her.
She wants to live in the property for two to three years as her primary residence. If she sells the property after two years for more than $100,000, will she have to pay a capital gains tax?
Also, will I have any increase in taxes when she sells the property and I get paid the remaining balance of the loan?
When you sell your rental property, the Internal Revenue Service will require you to recapture any depreciation you’ve taken over the years at a rate of 25 percent. You’ll need to do that by April 15 of the year following the sale. So, if you sell the property to her in 2016, you’d need to report the sale on your federal income tax form filed April 15, 2017.
If you’ve owned the property for a short period of time, the recapture tax may not be so much. You need to understand that when you own investment real estate, you may be able to get a tax benefit. You can deduct the cost of interest on any loan, the cost of real estate taxes, insurance, repairs, etc., and you can also depreciate the value of the building. If the value of the property is $100,000 and the land value is $20,000, you can depreciate the $80,000 over 27.5 years or about $2,900 per year.
So without doing anything, the $2,900 depreciation per year lowers the amount of taxes you might pay on profits you may have on your tax return by about that amount. It gets quite complicated, but in essence, depreciation can help lower your income taxes every year. But when you sell the property, the IRS expects to get repaid for the benefit you received from the depreciation by taxing you at about 25 percent on the depreciation you took. So if you took three years of depreciation or about $8,700, you’d have to repay the IRS about $2,200 when you sell the property.
To make this loan legitimate, you’ll need to do an “arm’s length” transaction and charge your daughter some real amount of interest. Because interest rates are so low, you should be able to set up the loan at 2 or 2.5 percent interest, which is what many banks are charging. The IRS has a table of interest rates you can use to determine the lowest interest rate you can charge without causing an issue for you or her on your federal income tax returns.
You could also give the property to your daughter. If you give it to her, she’ll receive it at the $100,000 price you paid for it. But by making it her primary residence, she’ll be entitled to keep up to $250,000 in profits tax-free when she sells, as long as she lives in it for at least 24 months which, as we understand it from your letter, is the plan.
This might be the simplest thing to do, since you won’t have to hire someone to write and file loan documents for you. What you should do, however, is work with a real estate attorney to facilitate the transfer so that it is handled correctly. (By the way, we’ve assumed you no longer have a loan on the property. If you do, it could complicate things a bit, since the loan will generally prohibit you from transferring ownership without repaying the loan.) You’ll have to decide whether selling the property to her is right for you and her.
Ilyce Glink is the creator of an 18-part webinar+ebook series called “The Intentional Investor: How to Be Wildly Successful in Real Estate,” as well as the author of many books on real estate. She also hosts the “Real Estate Minute” on her YouTube channel. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them at ThinkGlink.com.