I would like your thoughts on a tax issue that I’m dealing with. The issue relates to my mother’s 2015 tax return. Because of some health issues, her accountant had applied for an extension in October, which we had received. The issues deal with the sale of her home. My mom and dad purchased the home about 30 years ago and they paid $125,000. In 2015, my mom moved into a senior facility and we sold the home. My mom received $485,000 on the sale of the home. I was shocked when I just received her tax return and the accountant said she would have to pay taxes on the sale of about $110,000. He said that she gets a $250,000 exemption and everything else is subject to tax. My question to you: is that right and is there anything that we can do about it? You should know my father passed in 2012.
The accountant is correct that your mother is entitled to a $250,000 exemption. Individuals who live in their house for at least two of the last five years can exclude $250,000 of gains from taxes. Married couples can exclude $500,000 of gains. With regard to widows, if they sell their home within two years of their spouse’s death, then they also will receive a $500,000 exemption. Since your father died more than two years before she sold the house, the accountant is correct that the only exemption is the $250,000. That being said, I think there is something else you should explore that may reduce the taxes dramatically.
Since your mother and father owned the home jointly, upon your father’s death, your mother is entitled to receive what is known as a stepped-up basis on his one-half of the property. When someone inherits property, their new cost basis for determining gains and losses is not what the decedent paid for the property but rather, what its fair market value was on the date of death. Therefore, in the situation at hand, you need to go back and determine the value of the home at the time of your father’s death. For example, if upon your father’s death the house was worth $400,000, your mom’s new basis in the property would be one-half of the original purchase price, plus half of the fair market value as of the date of death. Therefore, moving forward her new basis would be $262,500 ($125,000 x ½, plus ½ x $400,000). Based upon these new numbers, her gain on the sale of the property would be the $485,000 less her new basis of $262,500; thus, her gain would be $222,500. Since this number is less than the $250,000 exemption, which she is entitled to, the total sale should be tax-free. Of course, the key is the value of the property as of the date of death.
Another issue that would further reduce any potential gain would be any improvements your parents did to the home while they lived there. Repairs and maintenance do not increase your basis but home improvements do. For example, if your parents put in new carpet, redid their kitchen or bathroom that would increase their basis. Remember, if any improvements were completed prior to your father’s death, half of those costs would be used to increase your mother’s basis. In regard to any improvements done after your father’s death, your mother would be entitled to increase her basis by 100% of the cost.
Because the exemptions are substantial, the great majority of people no longer pay taxes on the sale of their home. However, tax laws change and that is why I believe when you do home improvements such as adding a new addition or redoing your kitchen, it makes sense to save the receipts. They potentially can be very useful when you go to sell your home.
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at firstname.lastname@example.org