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What's the tax bite on gifting a home that's been used for business?

May 15, 2012: 5:05 AM ET

My wife has had a home-based business for the last 25 years and is now ready to retire. She has depreciated our home over that time to help offset income. The home will be paid for in five more years. At that time, I would like to deed the property to an LLC that my wife and I own for that purpose. We will then "gift" our ownership shares to our two children. Will my wife and I owe any additional taxes due to the depreciation that has been taken? Will my children have to worry about paying taxes if they choose to sell?
-- W. H., Omaha

If you've depreciated the entire home over the past 25 years, you may have some tax issues of a separate sort. "Unless the home was used entirely for business, you cannot write off 100% of the cost," says Donald Duncan, a financial planner and CPA in Chicago. Assuming you stick to your current plan, however, recapturing any depreciation won't enter into the picture until the home is sold—and may not be a problem at all. It's a complicated issue tied to how much you paid for the home, how long you've owned it, how much you depreciated, and when you sell.

The real question is why you're doing this at all. Are you trying to gift assets to your children to remove them from your estate? And are you also trying to stay under the gift tax exemption amount at the same time? You can't gift fractional shares of your home, and you're only allowed to gift up to $13,000 per person per year without using up some of your lifetime gift tax exemption. Hence, deeding the property to an LLC and gifting ownership shares to your children over time is a clever solution to that problem.

However, this move creates a different issue for your children. If you gift the home in this way, they retain the same cost basis that you have—and when they sell, if the home is not their primary residence, they'll owe capital gains taxes on every cent of appreciation since you bought it. One of your children would have to move into the home and use it as her primary residence for two out of the five years before the sale to save on taxes—she would then qualify for the $250,000 tax exemption if she's single, twice that if she's married. (Although she then may have to deal with depreciation recapture, depending on how much of the home you depreciated.)

If, on the other hand, you leave the home to your children in your will, the cost basis would be reset to its market value when you die, and your children could then sell it, tax- and depreciation-consequence free. It would still be a part of your estate, but there's currently a $5.12 million estate tax exemption in place.

Depending on your goals, it's probably a good idea to consult a tax-savvy financial planner before you move forward. "The tax consequences could backfire," Duncan says.

--Kate Ashford

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