Gifting Depreciated Rental Property: Tax Consequences

Gifting a rental property after its market value has dropped below the owner’s adjusted cost basis triggers a specific set of tax rules. This scenario differs from gifting appreciated property or inheriting property, which have their own tax treatments. The regulations for depreciated gifts are designed to prevent the artificial transfer of tax losses. These rules create distinct consequences for both the donor and the recipient that unfold from the initial transfer to the property’s eventual sale.

Tax Consequences for the Donor

When gifting a rental property, the donor’s primary tax consideration is gift tax. The gift’s value is its fair market value (FMV) on the transfer date. If this value exceeds the $19,000 annual gift tax exclusion for 2025, the donor must file a Gift Tax Return (Form 709) with the IRS.

Filing Form 709 doesn’t automatically mean taxes are due. The amount exceeding the annual exclusion is applied against the donor’s lifetime gift and estate tax exemption of $14.1 million for 2025. No out-of-pocket gift tax is owed if the donor’s cumulative lifetime gifts are below this limit. Married couples can combine their annual exclusions, gifting up to $38,000 per recipient annually without filing a return.

Another consequence for the donor involves the treatment of suspended passive activity losses. These are losses from prior years that the donor could not deduct. When the property is gifted, the donor loses the ability to deduct these suspended losses. Instead, these losses are added to the recipient’s basis in the property.

Determining the Recipient’s Basis

For the recipient, basis is used to calculate depreciation and determine gain or loss on a future sale. When a gifted property’s value is below the donor’s adjusted basis, a “dual-basis” rule applies. This means the property has two basis figures, and the one used depends on whether the property is later sold for a gain or a loss.

To calculate a potential gain on a future sale, the recipient uses the donor’s adjusted basis at the time of the gift. The donor’s adjusted basis is their original purchase price, plus capital improvements, minus all depreciation deductions claimed. This carryover basis rule ensures that the potential gain the donor would have realized is passed on to the recipient.

Conversely, for calculating a potential loss, the recipient must use the property’s fair market value (FMV) at the time of the gift. Since the property’s value has fallen, this FMV will be lower than the donor’s adjusted basis. This rule prevents taxpayers from “gifting” a built-in loss to someone in a higher tax bracket who could get a greater tax benefit.

Tax Implications When the Recipient Sells the Property

The tax consequences for the recipient crystallize when they sell the gifted rental property. The final sale price determines which basis figure is used and whether a gain, a loss, or neither is recognized. To illustrate, assume the donor’s adjusted basis was $250,000 and the FMV on the gift date was $200,000.

• Sale for a Gain: If the property is sold for a price higher than the donor’s adjusted basis ($250,000), that basis is used. A sale at $270,000 results in a $20,000 taxable capital gain.
• Sale for a Loss: If the sale price is lower than the property’s FMV at the time of the gift ($200,000), that FMV is used as the basis. A sale at $180,000 results in a $20,000 deductible capital loss.
• No Gain or Loss: If the property sells for a price that falls between the donor’s adjusted basis ($250,000) and the gift-date FMV ($200,000), the recipient recognizes neither a gain nor a loss on the sale.

The recipient also inherits the donor’s accumulated depreciation. If a sale results in a gain, a portion of that gain may be subject to depreciation recapture. Under Section 1250, the part of the gain from depreciation claimed by both the donor and recipient is taxed at ordinary income rates, up to a maximum of 25%.

Gifting vs Inheriting Depreciated Property

There is a significant difference between gifting a depreciated property and passing it on as an inheritance. The tax treatment for an heir is more favorable due to the “stepped-up basis” principle. When a property is inherited, the heir’s basis is adjusted to the fair market value of the property on the date of the original owner’s death.

This step-up in basis effectively erases the tax implications of any prior depreciation. For example, consider a rental property with an adjusted basis of $250,000 but an FMV of $200,000. If this property is inherited when the FMV is $200,000, the heir’s basis becomes $200,000 for calculating all future gains and losses, unlike the dual-basis rules for a gifted property.

The practical difference is that if the heir immediately sold the property for its $200,000 FMV, they would recognize no gain or loss. The stepped-up basis provides a clean slate, eliminating the built-in loss and providing a higher basis for future depreciation deductions if the heir continues to operate it as a rental. For this reason, holding onto a depreciated property until death is frequently a more tax-efficient strategy.