What Happens When Selling Real Estate Under Fair Market Value
Recently, we helped a client with the following situation:
The client wanted to sell a piece of real estate with a Fair Market Value (FMV) of $3mm to his sons for $1mm – thereby creating a gift of $2mm – and wanted to know what the resulting depreciable basis would be for his sons.
Generally, under §1015, the basis of property acquired by gift is the basis of the property (as adjusted under §1016) in the hands of the transferor. However, if at the time of the gift the FMV of the property is lower than the adjusted basis of the property, the FMV of the property is used in determining any loss on disposition of the property, thus creating a split-basis property.
Below, we outline three scenarios of how this could play out, then share the final outcome.
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Scenario 1: Assume the client’s situation above – that the father has an adjusted basis in the real estate of $1mm – but gifts the property to his sons for zero consideration.
The father’s $1mm basis transfers to the sons and is used to determine any future gain or loss on subsequent disposition. If the sons sell the real estate immediately for $3mm, they will have a $2mm gain ($3mm – $1mm). Conversely, assume they held the real estate for 10 yrs, the value decreases, and they can only sell it for $500,000. In that case, they’ll report a $500,000 loss ($500,000 – $1mm; ignoring depreciation).
Now change the facts slightly and assume the FMV of the real estate is only $500,000 on the date of the gift. In that case, the sons will have the same $1mm basis in the asset for gain purposes, but only a $500,000 basis for determining a loss. For an immediate sale at FMV, there would be no reportable loss ($500,000 – $500,000) even though economically they would have incurred a $500,000 loss ($500,000 – $1mm). If instead, the sons were to hold the real estate long enough for it to appreciate in value to $2mm, they would report a $1mm gain ($2mm – $1mm).
But what happens if the property is sold for more than it’s FMV, but less than the transferor’s adjusted basis? Assume the property is ultimately sold for $750,000. The transferees would incur a $250,000 economic loss ($750,000 – $1mm), but they wouldn’t be able to report it because for loss purposes, there isn’t one ($750,000 – $500,000)! Therefore, taxpayers should carefully consider alternatives to gifting property with a built-in loss.
In addition to the carryover basis from the transferor, the transferee’s basis is increased, but not above the FMV of the property, by the amount of the gift tax paid with respect to such gift which bears the same ratio as the net appreciation in value of the gift bears to the amount of the gift. See §1015(d)(6). The net appreciation in value of any gift is the amount by which the FMV of the gift exceeds the transferor’s adjusted basis immediately before the gift. Therefore, gifts that have a split basis due to having a FMV that is less that the adjusted basis of the transferor at the time of the gift cannot increase the transferee’s basis for any part of any gift taxes paid.
Scenario 2: Assume once again a $3mm FMV of the property, the $1mm transferor basis, zero consideration from the transferees, a 40% gift tax rate, and ignore all exclusions, credits, and deductions.
The father would be making a $3mm gift of the property to his sons and would owe $1.2mm in gift taxes without the exclusions. The sons would have a carryover basis in the property of $1mm plus a portion of the gift taxes actually paid with respect to the gift.
To determine that portion, the net appreciation in value of the gift of $2mm ($3mm – $1mm adj. basis) is divided by the $3mm taxable amount of the gift and then multiplied by the gift taxes paid ($2mm/$3mm * $1.2mm) to get $800,000.
Ultimately, under these facts, the sons would have $1.8mm of basis in the gifted real estate.
It’s important to note that only taxes actually paid are eligible to increase the basis of the gift. If no taxes are owed due to the annual exclusion, unified credit, charitable deduction, or marital deduction, there is no increase to the transferee’s basis.
But what happens when the transferee pays something for the property, but less than the FMV as in our client’s situation? Do they get additional basis for the consideration paid? Unfortunately, they don’t.
Where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the property in the hands of the transferee is the greater of the amount paid by the transferee for the property or the transferor’s adjusted basis in the property at the time of the transfer. This amount is increased by the amount of allowable gift taxes paid as discussed above.
Scenario 3: Assume our original facts except the transferor’s basis is only $500,000. The transferees take the higher $1mm basis for the consideration paid.
This makes sense because under Reg. §1.1001-1(e)(1), the transferor has a gain to the extent that the amount realized exceeds their adjusted basis in the property ($1mm – $500,000), so $500,000. The transferee’s paid $1mm for the property, so under the general rule of §1012, their basis is the cost of the property.
Now consider the opposite situation, where the adjusted basis of the transferor is greater than the consideration paid by the transferee. (Assume the transferor’s adj. basis is $1mm and the consideration paid was $500,000.)
The transferor has made a $2.5mm gift ($3mm – $500,000) and incurs a $500,000 economic loss ($500,000 – $1mm) but doesn’t get to report it. See §1.1001-1(e)(1). The transferees have paid $500,000 for the property and would normally take that as their basis under the general rule, but under §1.1015-4(a)(1), they get to carryover the transferor’s basis of $1mm which equals the consideration paid plus the transferor’s unreported loss.
Conclusion: In our client’s situation, since the consideration paid was higher than father’s actual adjusted basis, the sons took a $1mm basis in the real estate. The father reported a small gain and the $2mm gift but paid no gift taxes due to the annual exclusion and the lifetime unified credit. Accordingly, there was no increase to the transferee’s basis for gift taxes paid.
Transferees are not subject to the “step into the shoes” anti-churning rule for carryover-basis property at §168(i)(7)(A), so the property’s depreciation recovery period reset upon completion of the gift.
Additionally, the property did not qualify for bonus depreciation because property acquired by gift does not qualify as property acquired by purchase. See §1.168(k)-2(b)(3)(iii)(A)(2) & 1.179-4(c)(1)(ii) & (iv).
If you have client’s considering gifts of depreciable property, keep these rules in mind and don’t hesitate to reach out with any questions.
