Gifting of Rental Property

[Patrick Michael]

Owner of a rental property wants to sell and will have a hefty tax bill.  The son wants to gift the property to his father (there doesn't appear to be any gift tax issues other than filing the return).  The father has a terminal illness and is not expected to live for more than 6 months.  The father gets the son's cost basis and reports the rental income/expenses on his tax return.  The property is then willed back to the son when the father passes, and the son gets the stepped up basis.   Son then sells property, possibly at a loss when the selling expenses are factored in.  There is no other purpose of this transaction other than avoiding the tax. 

This doesn't pass the smell test to me.  Can the IRS disallow the step up in basis?  Any other issues with this scenario?

[jklcpa]

Quote

From pub 559:

The basis of certain appreciated property the estate receives from the decedent will be the decedent's adjusted basis in the property immediately before death. This applies if the property was acquired by the decedent as a gift during the 1-year period before death, the property's FMV on the date of the gift was greater than the donor's adjusted basis, and the proceeds of the sale of the property are distributed to the donor (or the donor's spouse).

"Appreciated property" is defined as “any property if the fair market value of such property on the day it was transferred to the decedent by gift exceeds its adjusted basis.”

[BulldogTom]

IRS could invoke the Step Transaction Doctrine.   Tax Advisor has a nice article on it - https://www.thetaxadviser.com/issues/2021/may/step-transaction-doctrine.html   If you don't like links (like me) here is a brief overview.

The IRS may apply the step-transaction doctrine, a rule of substance over form, in a variety of taxpayer circumstances to deny tax benefits derived from a series of transactions that should more properly be treated as a single transaction.

The courts have developed three tests to analyze whether the step-transaction doctrine applies to a series of transactions: the end-result test, the interdependence test, and the binding-commitment test.

Under the end-result test, if the separate transactions were component parts of a single transaction intended from the outset to produce the ultimate result, the step-transaction doctrine would apply.

Tom
Longview, TX

[jklcpa]

I don't think that tracing would come into play.  The code is clear on what the inherited basis of this rental would be under this client's scenario.  There is nothing to be gained by this transaction. It would cost the client money in terms of transfer taxes and legal fees to gift to the father, and then more in legal and probate fees to settle the estate for the solely owned rental to pass back to the son...all to end up with the virtually the same basis as before.

The code section this falls under is IRC sec 1014(e). It requires that the donee survive for at least one year after the transfer and limits tax-free transfers to a terminally ill person and the step-up.  IRS also ruled that this applies to property in a joint revocable trust funded with assets that were held by the grantors as tenants by the entireties.

Some history:
2001 - EGTRRA repealed sec 1014, and a carryover basis position was implemented under IRC sec 1022.  This applied to decedents passing after December 31, 2009.  Sec 1022 treated basis of property received from a decedent as if a gift with basis equal to the lesser of the decedent’s adjusted basis of the fair market value as of the date of death.

2010 - TRA reinstated the estate tax and fair market value basis at death provisions, and repealed the IRC Section 1022 carryover basis for decedents passing after 2009. 

Edited May 20, 2024 by jklcpa

[BulldogTom]

@jklcpa  Assuming the father lives for 1 year, do you think the transaction survives scrutiny by the IRS if the OP is carried out as planned by the taxpayer?

Tom
Longview, TX

[mcb39]

Don't forget about adding back the depreciation.  I, for one, wouldn't touch this.  If you owe, you owe!  I have had several sales of rental properties that didn't turn out so badly.

[jklcpa]

4 hours ago, BulldogTom said:

@jklcpa  Assuming the father lives for 1 year, do you think the transaction survives scrutiny by the IRS if the OP is carried out as planned by the taxpayer?

Tom
Longview, TX

I don't know for sure that it wouldn't be challenged, but I would not advise the client to do this.  As Marilyn said, I wouldn't want to touch this.

[Patrick Michael]

Thanks for input.  It sounded too good to be true.  

 

[DANRVAN]

On 5/20/2024 at 5:51 AM, Patrick Michael said:

The son wants to gift the property...........................  The property is then willed

In that case it is not a gift.

One of the elements of gifting is intent.  This is obviously not a transfer made out of affection, gratitude....etc.

A gift must be a unilateral transfer with no strings attached, meaning there is no action required on the part of the donee.

In this case there is a condition that the property is willed back to the donor by the donee.