If property is held for less than one year before it is sold, the seller cannot claim capital gains treatment. Instead, the profit is taxed as ordinary income. If, for example, your daughter is in a 30 percent tax bracket, she would have to pay as much as $111,000 in federal income tax. However, because she received a gift from you, the time in which you owned the property is added to her holding period. Assuming that you have owned the property for more than one year, your daughter would be taxed at 15 percent, which is the current rate for capital gains. Even so, she would still have to pay the IRS $55,500, plus any applicable state and local tax.
She could instead decide to move in and make the house her principal residence. If she owns and lives in the property for two out of the five years before it is sold, she can exclude up to $250,000 of any profit (or up to $500,000 if she is married and files a joint tax return). Again, that profit is calculated using your low tax basis. While we all hope that property values will appreciate in the years to come, even if she gets only $500,000 for the house, she might still have to pay some tax on her gain, especially if she is not married. And clearly, if she sells the house and makes a profit of more than $500,000, she would owe money to the IRS.
If your daughter decides not to move in, she could consider a Section 1031 exchange, also known as a Starker or like-kind exchange. This is a way to defer taxes on profit from the sale of investment property. Once again, there is a big risk. To have a successful exchange, the property being exchanged (called the "relinquished" property) must have been held for investment. If she immediately put the property on the market after taking title from you, the IRS would take the position that the house was not "held" for investment and would reject the exchange transaction.
Finally, your daughter could rent out the house and become a landlord. Under this scenario, while she could later do a Starker exchange, she would have lost the opportunity to claim the up-to-$500,000 gain exclusion.
Now, let's change the facts. You decide to leave the property to your daughter after you die. Your daughter would be able to take advantage of what is known as the "stepped-up basis." In simple terms, this means that the value of the property on the date of your death becomes the basis for the person who inherits the house.