Ask Liz Weston

Get smart with your money

step-up in basis

Q&A: Why marriage can reduce taxes on a home sale

By

Dear Liz: We are a heterosexual couple who are registered domestic partners in California. We have owned our primary residence for decades. Obviously, its value has increased and is well past the $500,000 home sales exemption limit for couples.

When one of us passes away, how is the basis and the appreciation of the residence calculated for federal and state taxes? Does the step-up basis come into play for both federal and state taxes when calculating capital gains? We do not have any children and are leaving the bulk of our estate to charity.

Answer: California offers the valuable double step-up in tax basis to registered domestic partners, but the federal government does not.

In most states, one half of a couple’s jointly owned property gets a new value for tax purposes when the first partner dies. This step-up in value eliminates capital gains taxes on any appreciation that happened during the deceased partner’s ownership.

In community property states, however, both halves of jointly owned property can get the step-up in value when the first spouse dies. California generally treats registered domestic partners the same as married couples, but IRS Revenue Ruling 2013-17 and Regulation 301.7701-18(c) specify that “marriage” and “spouse” do not include registered domestic partnerships for federal tax purposes, according to Wolters Kluwer Tax & Accounting.

Let’s say you bought the house for $300,000 in the 1980s, invested $100,000 in upgrades over the years and it’s worth $2 million today. The current tax basis would be $400,000 (the sales price plus the upgrades). That’s the amount the two of you would subtract from the sales price to determine the potentially taxable capital gain. You could exempt $500,000 of the home sale proceeds ($250,000 per owner) since you’ve owned and lived in the property at least two of the past five years. That leaves a taxable gain of $1.1 million.

If one of you died tomorrow, only half of the property would get stepped up to the current market value for federal tax purposes while the other half would retain its $200,000 basis for a total basis of $1.2 million. For state tax purposes, both halves would get the step-up so the new tax basis for state taxes would be $2 million.

Something else to consider: a federal law allows the full $500,000 exclusion for surviving spouses if they sell the home within two years of the death. That provision is not extended to registered domestic partners.

As you can see, a marriage certificate could make an enormous difference if the survivor wanted or needed to sell the home after the first death.

Marriage confers a number of other benefits under federal law. A spouse can receive Social Security spousal and survivor benefits, for example, but registered domestic partners aren’t eligible for benefits on a partner’s earnings record. Spouses also have special rights with IRAs and employer retirement plans, such as being able to treat an inherited IRA as their own. Non-spouse beneficiaries, including domestic partners, generally must empty the accounts within 10 years.

Your mileage may vary, but the benefits are numerous and valuable enough to make marriage worthwhile in many cases. Please talk to your tax pro and estate planning attorney for individualized advice.

Q&A: Should I get a home appraisal when my spouse dies?

By

Dear Liz: When one spouse dies, the couple’s primary residence gets a step-up value to the current market value (in California). So how is that value established for future reference? Is it necessary to get a formal appraisal or are current sales comparisons sufficient? Also, is that step-up value the basis for any future home sale or would the sale have to happen in a certain time frame?

Answer: It’s a good idea to get a formal appraisal after a spouse dies to establish the home’s value and potentially reduce future taxes. There’s no deadline for using this new tax basis, but surviving spouses who sell within two years of the death can get the full $500,000 capital gains exclusion available for couples. After the two-year mark, survivors would be limited to the individual $250,000 limit.

Here’s a quick primer on how step-up works. In every state, the deceased spouse’s half of jointly owned property gets a new value for tax purposes. This step-up in tax basis means that no capital gains taxes will be owed on the appreciation that happened during the deceased spouse’s ownership, at least on 50% of the property.

In community property states, both halves of the property typically get this valuable step-up in basis at the first spouse’s death. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

If an appraisal wasn’t ordered soon after a death, getting a formal valuation can be somewhat more complicated. Your estate planning attorney may be able to guide you to appraisers experienced in retrospective valuations.

Q&A: Only married couples in community property states get this tax benefit

By

Dear Liz: I own a house with my longtime boyfriend. If one of us dies, how does the capital gains step-up affect the other?

Answer: The deceased partner’s share of the home will get a new basis for tax purposes. The survivor’s share will not.

Tax basis helps determine how much of a capital gains tax bill you might face when you sell a home or any other asset that gained value over time. Your basis is generally what you paid for the home, plus qualifying improvements.

Inherited assets typically get a step-up in tax basis to their current market value, which means that no one has to pay taxes on the appreciation that occurred during the original owner’s lifetime.

If you were married and living in a community property state such as California, then the entire house could get stepped up to the current market value when the first spouse dies. This is known as the double step up. But this applies only to married couples in community property states. Unmarried couples in community property states and couples in other states don’t get this benefit.

Myths about “death taxes” lead to costly mistakes

By

Dear Liz: You recently answered a question about capital gains taxes that stemmed from two siblings selling their parents’ home. The children had been added to the parents’ deed, presumably before the parents’ death. You mentioned that the capital gains tax would have been avoided if the parents had bequeathed the home rather than gifting it during their lifetimes. Presumably bequeathing the home at death would have necessitated probate and incurred inheritance taxes. Are these costs more than offset by the stepped-up tax basis received?

Answer: Your questions illustrate exactly why no parent should add a child (or anyone else) to a home deed without discussing the issue with an estate-planning attorney first. Too often, laypeople misunderstand what’s involved in probate and make expensive mistakes trying to avoid it.

In some states, probate — the court process that typically follows death — is relatively swift and not very expensive. Trying to avoid it isn’t necessarily cost effective. In other states, including California, the process potentially can take many months and eat up a good chunk of an estate. When that’s the case, it can be prudent to take steps during life to sidestep probate at death.

There are often better ways to do so, however, than adding someone to a deed. A living trust, for example, can be a good way to avoid probate and preserve the tax benefits of bequeathing, rather than gifting, assets. Living trusts can vary in cost, but a lawyer can typically set one up for $2,000 or $3,000. If you compare that with the $25,000 or more the siblings will pay in capital gains on a relatively modest home sale, you can see that the living trust probably is a better deal.

Now let’s turn to the issue of estate taxes. If the assets left by the deceased are substantial enough to incur estate taxes, they will do so whether or not the estate goes through probate. Avoiding probate, in other words, does not avoid estate taxes. Currently, only estates worth more than $5.12 million face federal estate taxes. That limit is scheduled to drop next year to $1 million, but will still affect relatively few estates.