Q&A: The tax implications of downsizing

Dear Liz: My mother just turned 75 and wants to downsize from her four-bedroom house. My father passed away six years ago. She owns her home outright, and at the time of my father’s death the value of the house was estimated at $1.2 million. Right now she has enough income from retirement accounts and investments to live comfortably. She could even buy another smaller property if need be. As the executor of her estate, I’m trying to help her decide what to do with the house. She could let another family member live in it who couldn’t pay rent but could help with upkeep; she could rent it out for market value; or she could sell. We see advantages and disadvantages with all three options. What do you think?

Answer: If she hasn’t already, your mother needs to hire a good estate-planning attorney who can help her evaluate her options. Consulting a fee-only financial planner and a tax pro may be a good idea, as well.

If she sells, your mother could face a sizable capital gains tax depending on where she lives. Federal law allows a certain amount of capital gains on the sale of a primary residence ā€” $250,000 per person ā€” to be excluded from income, but after that, capital gains taxes apply.

The gain would be the difference between the home sale proceeds and your mother’s tax basis in the home. At least half of the home received a “step up” in basis to the then-current market value when your father died. If your mom lives in a community property state, such as California, both halves of the property would have received this step up at his death. Any increase in value since then would be subject to capital gains tax (minus, again, the $250,000 federal exclusion).

There’s another tax issue to consider. If she dies owning this house, her heirs would get a tax basis equal to the property’s value at her death. In other words, regardless of the state where she lives, none of the house’s appreciation during her lifetime would be taxable.

The tax issues alone shouldn’t dictate what your mother does. But she should be aware of them to make an informed decision about what to do next.

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Comments

  1. Whitney Wilson says:

    Hi Liz
    If we live in a community property state, California, and both halves of a home receive stepped up basis upon the death of husband or wife,would that also true of securities brokerage account?
    Thanks, Whitney

    • Liz Weston says:

      It’s my understanding that any asset held as community property gets this benefit, but you’ll want to check with an estate planning attorney.

  2. Some of the terminology is confusing to me so let me ask a question. We bought our home for $150,000. We could sell it for $600,000. This would be an increase of $450,000 (before paying commissions, fees). In this scenario, my husband and I would be under the $250,000 each? Or is it based on the $600,000 even though the profit is less than that.

    Guess I’m better when an example is given. Live in Calif. Thanks for your response.

    Murph

    • Liz Weston says:

      You wouldn’t have a taxable gain currently, since the two of you can exempt a total of $500,000 of home sale profits. If one of you should die, the surviving spouse’s tax basis would be “stepped up” from $150,000 to the current market value of $600,000 (since in California both halves of the property get the new value). The house would have to appreciate more than $250,000 from that point–to a sale price more than $850,000–before the survivor would owe capital gains. In most states, however, only one half of the property gets a step-up in basis when one member of a couple dies.

  3. Don’t rent – the home then becomes business expense and is taxed at capital gains – so you do not get the capital gains $250,000 exemption for a private home! Rental property when you sale it falls under capital gains tax on the profit of the sale of the property! If she keeps it as her primary home she has no tax up to the exemption amount when she sales it. Some people PAY their relatives to house sit the home till they are ready to sale. It would be a shame for her to pay capital gains tax (15% or more) on the profits of the home just by renting it 1-3 years if she plans to sell it at a later date. Note: I have a friend with property worth 5 million. She is not selling it because of the tax she would need to pay. By keeping the property she gets to give it to her children tax free upon her death. Work the numbers with your mother. Another thought – look at Europe’s economy – you might think it prudent to sell if housing drops. A nice stat – if a person lives to 63 without any major health problems, their chances to hit 85 are very good! Main thing – do what sees to cause her the least amount of stress. Having cash on hand might be the thing, keeping the house might be what gives her peace of mind, or saving money for family fits her. You are lucky she has choices. Wishing her many years of good health.