You may be familiar with the Section 121 Residence Exclusion without really being aware of it. This is the actual name for the tax benefit that protects owners from taxation on the sale of their primary residence, specifically gains of up to $250,000 (single)/$500,000 (joint). This “exclusion” amount applies to a personal residence in which the owner(s) lived for at least two of the previous five years.
But in the case of a jointly-owned property, what happens if one spouse passes away and the property is subsequently sold? Unfortunately, after two years, the exclusion would revert to the single owner amount of $250,000. This means that depending on the amount of the capital gain in the property, the surviving spouse may be subject to a larger tax than expected.
The solution? Have the property appraised to document the partial step-up in basis.
Let’s look at an example:
Bill and Susan are both 70 years old. They’ve jointly owned their home for more than 30 years and paid $100,000 for it. At the beginning of the year, they started talking about downsizing to a smaller, single story home that will be more manageable for the next phase of life. Unfortunately, Bill becomes unexpectedly ill and passes away before they take any action on selling the home.
After taking a few years to settle into her life without Bill, Susan inquires about selling the home. Her real estate agent estimates that the home will likely sell for $700,000. This is $600,000 more than the $100,000 they paid. If Susan sells this property, she will only be able to avoid paying taxes on $250,000 of the gain and pay capital gains taxes on the remaining $350,000.
What Susan may not be aware of is that she is eligible for a step up in basis for 50% of the property. This means instead a cost basis of $100,000 for her home, the new basis would be 50% of the appraised value ($350,000 on a $700,000 appraisal) plus 50% of the original basis ($50,000). The only action that’s needed is for Susan to pay for a formal appraisal of the home before she puts is on the market.
So if the home appraises and sells for $700,000 and her basis is now $400,000, her capital gain would be $300,000. After the $250,000 exclusion she receives as a single-filer, she would only owe capital gains tax on $50,000. The chart details the two scenarios.
Assuming an apples-to-apples comparison using a 15% capital gains rate, paying a few hundred dollars for an appraisal before it goes to market could potentially save Susan $45,000 or more in taxes. Keep in mind that above $200,000 in net investment income, Susan may be subject to an additional 3.8% Medicare tax, and if her taxable income is above $441,450, the capital gains rate can increase to 20%.
It's important to note that surviving spouses may exclude $500,000 of capital gain from a home sale if sold within 2-years of their spouse’s death.
As always, it’s best to discuss all of this with your tax professional and your estate planning attorney.