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.

Q&A: Good reasons why one spouse’s inheritance doesn’t belong to the other

Dear Liz: You recently told a husband who wanted to spend his wife’s expected inheritance that the money would be her separate property. Is that true of all states or just community property states like California? Even if it can be kept legally separate, should it be? Isn’t it better for couples to share their money?

Answer: Inheritances and gifts are considered separate property in every state. Where community property and equitable distribution states differ is in how other assets and debts acquired during marriage are treated.

For inheritances and gifts to remain separate property, though, a recipient must be careful not to commingle them with joint funds. Recipients would need to keep such windfalls in separate bank or brokerage accounts in their names alone, for example, rather than storing the money in jointly held accounts, using it to improve a jointly owned asset such as a home or paying down a joint obligation such as a mortgage.

Why would people want to keep funds separate? There are good reasons, even in marriages where all other money is shared. The couple may divorce, or the wife could die before her husband. If she commingles her inheritance with joint funds, the money her mother intended her to have could ultimately get spent by her husband’s next wife.

The wife may well decide to share some or all of her windfall with her husband. But she shouldn’t be pressured or bullied into doing so, especially with the notion that it’s the “right” thing to do. She would be smart to talk — alone — to a fee-only financial planner who pledges to put her interests first before she makes any decisions about the money.