Bargain sale + Gift. Selling Your Rental Property to Your Relative with a “Gift of Equity”.

Imagine this real-life situation: You own a rental house that you have rented out for many years. The closing statement says the selling price is $170,000. But you are helping your son buy his first home, so you gift him $50,000 in equity. He only pays you (or the bank) $120,000 in cash.

At first, you (or your accountant) put the full $170,000 on Form 4797. You start worrying: “Am I going to pay tax on money I never received?”

Good news: You are NOT supposed to pay tax on the $170,000. You only report the $120,000 you actually received. The extra $50,000 is treated as a separate gift. This is 100% legal and very common for families. It is not tax evasion - the IRS even explains exactly how to do it in their own book, Publication 544.

Let’s walk through everything step by step, like you are explaining it to your neighbor over coffee.

1. Why You Only Report the $120,000 (Not the Full $170,000)

The IRS calls this a “bargain sale” - you sell for less than fair market value on purpose to help someone (in this case, your son).

According to IRS rules:

• The part you actually get in cash or check = sale → this creates taxable gain.
• The difference = gift → no income tax for you on the gift.

So on your tax return you write: Amount realized = $120,000 (only the real money you received).

The $50,000 is a gift. You do not pay income tax or capital-gains tax on it.

2. Important Fact: You Can’t Depreciate Land

Many people think “my rental is fully depreciated, so my basis is zero.” That is almost true - but not quite.

Land never wears out, so the IRS says you cannot depreciate land. Only the building (the house itself) can be depreciated over 27.5 years.

Realistic example with numbers everyone can understand:

• Years ago you bought the house + land for $200,000.
• County records showed: Land = $40,000 (20%), Building = $160,000 (80%).
• Over the years you depreciated the entire $160,000 building → it is now worth $0 on your books for tax.
• Your adjusted basis today = only the land = $40,000 (not zero!).

This is what really happens in 90% of cases. The building is gone for tax purposes, but the land still has value.

3. How Much Tax Do You (the Parent) Actually Pay?

You report on Form 4797:

• Amount realized: $120,000
• Your adjusted basis: $40,000
• Total gain: $80,000

Now the special rule for rental property:

• Depreciation recapture (the money you got back from all those years of deductions): Up to $80,000 of your gain (the lesser of your total gain or the depreciation you took) is called “unrecaptured Section 1250 gain.” You pay tax on this part at a maximum rate of 25% (not the normal income-tax rate).
• Any extra gain above that = regular long-term capital gain (usually 0%, 15%, or 20%).

In our example: You pay tax on about $80,000 total (mostly at 25%). You do not pay tax on the $50,000 gift.

4. Real IRS Example from Their Own Publication (Slightly Different Property)

Here is the exact example straight from IRS Publication 544:

“You transferred depreciable personal property to your son for $20,000. When transferred, the property had an adjusted basis to you of $10,000 and an FMV of $40,000. You took depreciation of $30,000.
You are considered to have made a gift of $20,000 (the difference). You have a taxable gain of $10,000 ($20,000 sale price minus $10,000 basis) that must be reported as ordinary income from depreciation. You report $10,000 of your $30,000 depreciation as ordinary income… so the remaining $20,000 depreciation is carried over to your son…”

For a rental house the math is almost the same, except the recapture rate is usually 25% instead of ordinary income. The important part: any unused depreciation carries over to your son.

5. What About Your Son? His Basis and Future Taxes

Your son’s tax “basis” (his starting cost for tax purposes) is $120,000 - exactly what he paid.

• The $50,000 gift part has zero basis carried over from you (because your building basis was already zero).
• If he keeps renting it out, he can start depreciating his new $120,000 basis over 27.5 years.

When your son sells the house later to a stranger (say for $250,000):

• His gain will be bigger because his basis is only $120,000 (minus any depreciation he took).
• He will pay recapture tax only on the depreciation he claimed.
• Any depreciation you did not recapture stays with the property - but in our example you already recaptured everything possible, so nothing extra for him.

This is the fair trade: You pay less tax now, your son pays a little more later. The IRS is happy because the tax eventually gets paid.

6. Which Forms Do You File and How Do You Fill Them?

For you (the seller/parent):

1. Form 4797 (Sales of Business Property)
   • Part III (for real estate)
   • Line for “Amount realized” → put $120,000
   • Line for “Adjusted basis” → put $40,000 (or whatever your real land value is)
   • The form will automatically calculate the gain and send the recapture part to your Schedule 1 or Form 1040.
   • Attach a short note: “Bargain sale with gift of equity of $50,000 to son - see attached gift letter and closing statement.”
2. Form 709 (Gift Tax Return) - only if the gift is over the annual limit
   • In 2026 the free amount is $19,000 per person.
   • Your $50,000 gift is $31,000 over the limit, so you must file Form 709.
   • You do not pay any gift tax unless you have already given away more than $15 million in your whole life.
   • Just report it and it reduces your lifetime exemption a little.

The title company will send you a Form 1099-S showing the full $170,000. That is normal. You ignore the 1099-S number and use the correct $120,000 on your return. The IRS expects this in gift-of-equity deals.

7. What Your Son Must Keep Forever

Your son needs to save these papers in a safe place (or digital folder) for when he sells the house someday:

• The closing statement from your sale
• The gift letter (the bank usually makes you sign one)
• A copy of your Form 4797 or at least the depreciation schedule
• His own future depreciation records

Why? So he (or his accountant) can prove his basis is $120,000 and not $170,000. If he loses the papers, the IRS may assume his basis is zero and he will pay way more tax!

Bottom Line

Selling to your son with a gift of equity is a smart, legal way families help each other buy homes. You pay tax only on the real money you received. The IRS knows this happens all the time and has clear rules for it.

Just remember three easy things:

1. Report only the cash you actually got.
2. Land is never depreciated - your basis is at least the land value.
3. Save every paper so your son doesn’t get a surprise tax bill later.

If your numbers are different (different purchase price, different land value, etc.), sit down with your tax preparer and show them this article plus your closing statement. They can plug the exact numbers into the software in five minutes.

You are not cheating the system - you are simply using the rules the IRS wrote. That’s exactly what they expect smart families to do!