Co-Author: Patricia A. Leighton, Esq.
Quit Claims & The $500K Exclusion
Consider the following parent who has allowed her adult son to live in her second house for the last 2 ½ years. The parent now wants to sell the house. Can the parent quit claim the house to her son so that he can benefit from the $250,000 capital gains exemption?
Question: Mom owns two houses: “Primary Residence” and “Cottage.” Mom purchased Cottage in 1980 for $25,000. Mom purchased primary residence in 1998 and has occupied it as her primary residence since then. In 1998, after Mom moved into Primary Residence, she agreed that her son (“Son”) could move into the Cottage. Title to Cottage remained in Mom. Son has lived in Cozy Cottage since 1998. In 2001, Son decided he wanted to buy and move into “Replacement Property.”
Mom wants to sell Cottage and let Son use the funds from the sale of Cottage as a down payment for Replacement Property. Real Estate Broker has estimated that the fair market value of Cottage is now $225,000. Some friends of Mom have told her that in order to minimize the federal income tax bite, Mom should quit claim Cottage to Son. That way (according to the friends), Son could sell Cottage and take advantage of the capital gains exclusion for the sale of a primary residence under IRC § 121. Should Mom quit claim Cozy Cottage to Son?
Answer: Section 121 of the Internal Revenue Code (IRC) states that, under certain conditions, a portion of the gain from the sale or exchange of a taxpayer’s residence may be excluded from the taxpayer’s gross income. In general, the amount of gain that is excluded from gross income is limited to $250,000. However, if a husband and wife file a joint return for the taxable year, the couple may exclude up to $500,000 of gain from the sale of their primary residence.
In order for the exclusion rule to apply, the taxpayer must have owned and used the property as the taxpayer’s primary residence for an aggregate of at least 2 years out of the previous 5 years. Generally, if the taxpayer has not satisfied the 2-year ownership and primary residence requirements, the taxpayer will not be allowed to exclude from gross income any gain realized on the sale of the house. A special exception applies if the taxpayer is forced to sell the house by reason of a change in place of employment or health, or if the sale is forced due to unforeseen circumstances.
Mom’s plan was to convey title to Cottage into the name of Son, enabling Son to take advantage of the IRC § 121 exclusion when he sold the house. However, the language of IRC § 121(a) is very clear regarding the two-year residency rule. A taxpayer will be allowed to exclude the gain on the sale of the property if “during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for period aggregating 2 years or more” (emphasis added). The taxpayer must satisfy both the ownership test and the use test for the 2-year residency requirement.
Although Son has used Cottage as his principal residence for more than 2 years, he has not owned Cozy Cottage for the required 2-year period. Son will have to own and use Cozy Cottage as his principal residence for at least another 2 years in order to qualify for the IRC § 121 exclusion when they sell Cozy Cottage.
So, what are the tax implications if Mom sells Cottage? The gain on the sale of a personal residence is classified as a capital gain under IRC § 1221. Property that has been owned by the taxpayer for at least 1 year is further classified as a long-term capital gain. The long-term capital gains tax rate for an individual taxpayer is 20%. A special 10% long-term capital gains rate applies if the individual’s top marginal tax rate is in the 15% tax bracket. If the property has been held for less than one year, the gain would be classified as a short-term capital gain and subject to tax at ordinary income tax rates.
If Mom sells Cottage, she must recognize capital gain in the amount of $200,000 (the difference between the $225,000 selling price and their original basis in the property of $25,000). Because she owned Cozy Cottage for more than one year, the gain would be classified as a long-term capital gain under IRC § 1222 and would be subject to a tax of 10% or 20% of the net capital gain, depending upon her top marginal tax rate.
If Mom conveys Cottage to Son, Mom will no longer be the owner of Cottage and will not have to recognize a gain on her income tax return if Son sells the property. (However, see note about possible gift tax consequences at the end of this article.) If Son sells Cottage before satisfying the 2-year ownership and usage requirements of IRC § 121, Son will have to recognize the capital gain on his tax return for the year in which he sells Cottage.
The amount of gain that Son must recognize will be the difference between the selling price and Son’s basis in Cottage. Under IRC § 1015, the donee (the recipient of the gift) of property has the same basis in the property (for purposes of calculating capital gain) as the donor had. So, based on the facts above, Son will have a $25,000 carry-over basis in Cottage. If Son then sells Cottage for the fair market price of $225,000, the amount of capital gain that Son will have to recognize on his income tax return will be $200,000.
The Internal Revenue Code does provide some relief to Son with regard to whether the gain will be long-term or short-term. IRC § 1222 provides that a donee of gifted property gets to “tack on” the holding period of the donor for purposes of determining whether the gain will be long-term or short-term. Under our fact situation, as of year 2001, Mom had owned Cottage for 11 years. If Mom gives Cottage to Son, Son will get to “tack on” to Mom’s holding period. Even if Son sells Cottage only three months after he takes title to Cottage, for purposes of determining whether the gain on the sale of Cottage is long-term or short-term capital gain, Son will be deemed to have owned Cottage for 11 years, 3 months. Thus, Son’s gain on the sale of Cottage would be treated as a long-term capital gain.
A more satisfactory result can possibly be achieved if Son continues to use Cottage as his primary residence for at least 2 years after Cottage is conveyed to him. If Son continues to own and use Cottage for an aggregate of at least 2 years within the 5-year period preceding the date he sells Cottage, Son will probably be able to exclude up to $250,000 of the gain under IRC § 121. If Son was married at the time of the gift, and he took title with his wife, then Son and his wife should be able to exclude up to $500,000 of the gain.
If Mom is considering any type of gift to Son (regardless of whether Mom intends to make an outright gift of Cottage or of the net proceeds from the sale of Cottage), Mom should also consider the gift tax consequences. Although a discussion of the gift tax consequences of a gift of Cottage (or of any annual gift in excess of $10,000 per donee) is outside the scope of this article, Mom needs to seek advice regarding the effect of the gift on her estate for purposes of the unified federal gift and estate tax system. If Mom has already used up what is called her “unified credit” as a result of other taxable gifts made by Mom during her lifetime, the gift tax consequences from gifting Cottage (or the proceeds from the sale of Cottage) to Son could be anywhere from 35% to 55% of the total value of the gift. Even if Mom has not used up her unified credit, the gift will erode a portion of her unified credit which could significantly increase Mom’s estate taxes upon her death. Mom’s gift tax problem might be solved or alleviated by means of a planned gifting program over time.
An estate planning specialist and a tax adviser can offer several alternative plans whereby Mom can transfer ownership of Cottage to Son with a minimal amount of federal income, estate and gift tax consequences.