Surviving spouses who wish to sell their primary residences often face large tax bills at an inopportune time. Good tax planning can help lessen the burden.
The recent appreciation of the U.S. real estate market has left many taxpayers with homes worth far more than their cost basis, or what they paid. A surviving spouse who wants to sell his or her primary residence can substantially reduce a large tax bill through the home sale exclusion in Internal Revenue Code Section 121, used in conjunction with an increase, or step-up, in basis received upon the death of the other spouse.
Generally, a married couple can exclude up to $500,000 of gain on the sale of a personal residence if at least one spouse has owned the residence and both spouses have occupied it for at least two of the last five years. Single taxpayers are allowed a maximum $250,000 exclusion.
Typically, married couples own a residence as joint tenants with right of survivorship and are considered to own half each. When one spouse dies, the survivor receives full ownership of the property, as well as a step-up in basis equal to half of its fair market value on the date of death. This effectively eliminates half of the gain that would have been realized upon sale of the property.
For example, John and Jane Smith purchase a property for $500,000 as joint tenants. If they were to sell the home for $2,000,000, their gain would be $1,500,000. As married taxpayers, they would receive a $500,000 home sale exclusion, resulting in a taxable gain of $1,000,000.
Assume, however, that John dies when the property has a total fair market value of $2,000,000. Jane then has full ownership of the property with a basis of $1,250,000 ($250,000 for her original 50 percent interest and $1,000,000 for the other half passed to her at John’s death). Her gain would be $750,000 when she sold the home, but her home sale exclusion would depend on when she did so. The rules allow a surviving spouse to claim the full $500,000 exclusion if a primary residence is sold in the same year as the other spouse’s death by filing a joint return for that tax year. Therefore, if Jane sold the home in the same calendar year in which John died, her taxable gain would be $250,000. But if she sold in a later year, she would receive only a $250,000 exclusion and her taxable gain would be $500,000.
Clearly, if a spouse dies late in the year, there are logistical problems in selling a residence that year. Imagine Jane’s predicament if John died on Dec. 1. Completing the sale by the end of the year would be unlikely, particularly in a slowing real estate market. In December 2005, the American Institute of Certified Public Accountants (AICPA) submitted a proposal to Congress recommending that a surviving spouse be given 12 months to sell a home rather than requiring that the sale occur within the same tax year. However, the law has yet to be amended. To the extent possible, a married couple who anticipate selling their primary residence after the death of one spouse should take steps to ensure that the sale proceeds efficiently.
An alternative worth considering in the right situation is for one spouse to transfer full ownership of the property to the other. If Jane were to transfer her ownership interest to John, she would receive a 100 percent step-up in basis at John’s death. This can be an attractive strategy, as it eliminates any capital gains on the property upon John’s death. However, it carries some risks, and taxpayers should be fully aware of the potential downsides. In particular, if Jane, having transferred her ownership, dies before John, he would not receive the 50 percent step-up in basis since he would own 100 percent of the property. Accordingly, this strategy is only appropriate if it is reasonably certain that one spouse will predecease the other, such as in the case of a couple with a significant age difference. In addition, Section 1014 of the Internal Revenue Code stipulates that any property transferred to a person within one year prior to his or her death will not receive the step-up in basis.
While these examples provide a general overview, there are many intricacies to state ownership law and the home sale exclusion rules. The above scenarios generally apply to common-law states. Community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin) generally treat marital assets as owned one-half by each spouse. Further, property inherited by any surviving spouse under community property laws receives a 100 percent step-up in basis, eliminating any guesswork.
While not historically a community property state, in 1998 Alaska enacted the Alaska Community Property Act. The law provides that nonresidents may create community property trusts. Any assets a couple transfers to a community property trust are classified as community property, allowing those assets to be subject to the more beneficial community property rules despite the fact that the couple resides in a common-law state. The law is still relatively new, and the Internal Revenue Service has not yet challenged nonresident couples who have created Alaska community property trusts.
Many strategies can be employed to sell or transfer a primary residence in a tax-efficient manner, some more complex than others. Taxpayers should consult a tax advisor before implementing any strategy. With careful planning, significant tax savings can be achieved.