Q&A: Figuring out capital gains when an inherited house is sold

Dear Liz: I’ve have been following your responses related to the tax exemption on home sales. I understand that up to $250,000 per person of home sale profit is exempt from capital gains taxes and that married couples are entitled to exempt up to $500,000.

My spouse and her two siblings inherited a home from their parents. My father-in-law passed away four years ago, and my mother-in-law died last year. My wife was assigned as executor of their living trust. Who is entitled to take the tax exemption of the proceeds from the sale of the house? My wife? All three siblings? All of the above and their spouses?

Answer: None of the above, but don’t despair because the house will incur little if any capital gains when it’s sold.

We’ll assume your mother-in-law inherited the house outright from her husband, since that’s usually the case. When your mother-in-law died, the house received a “step up” in tax basis to reflect its current market value. If the house was worth $2 million when she died, for example, that’s the new value for tax purposes — even if she and your father-in-law paid only $25,000 decades ago for the house. All the gain that occurred in between their purchase and her death won’t be taxed.

If your wife sells the house for $2.2 million, there potentially would be some taxable capital gain. But the costs of marketing and selling the home would be deducted from its sale price. If those costs are 6% of the sale price — which is a pretty conservative assumption — the taxable gain would be about $68,000. (Six percent of $2.2 million is $132,000. Subtract the $2 million value at death and the $132,000 of sales costs, and you’re left with $68,000.) If your wife as executor sells the house and distributes the proceeds to the beneficiaries, the estate would pay the tax. If siblings inherit the house and then sell it, they would pay any tax.

Every year, millions of dollars of potential capital gain vanish this way as people inherit appreciated property. It’s a huge benefit of the estate tax system that many people don’t understand until they’re the beneficiaries of it.

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Comments

  1. Robert Dudley says:

    Figuring Out Capital Gains etc. Your reply to a question on inherited home in current July 10 newsletter.
    At the end of your comments you say…..”If siblings inherit the house and then sell it they would pay any tax.” I believe you meant to say would not pay any tax. There ya go!

    • Liz Weston says:

      No, if they inherit the house itself, they would pay any capital gains tax owed upon the sale.

  2. “If your wife as executor sells the house and distributes the proceeds to the beneficiaries, the estate would pay the tax. If siblings inherit the house and then sell it, they would pay any tax.”

    I believe this statement is incorrect. If the funds are distributed – the gain follows the money and the heirs will pay the tax on the gain at their tax rate on their personal 1040 returns. If the funds are not distributed in the same tax year then the estate could pay the tax before distribution.

    • Liz Weston says:

      I run my answers about estate planning past Los Angeles estate planning attorney Burton Mitchell. He confirmed the wording is correct. Capital gains in this situation are generally treated as principal and don’t pass to the beneficiaries. There are some limited exceptions, he said, but they don’t apply here.