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 — $250,000 per person — 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.