Say in 2014 a mother transferred the deed to her house to her son and retained a life estate. She then died in 2016. She paid $18,000 for the house in 1960. It is the son’s primary and only residence. He wants to put the house on the market for $375,000. Will he have to pay capital gains taxes if he sells the house in 2021?
Nj.com’s recent article entitled “Will sale of inherited home cause a tax liability?” explains that the profit can be calculated by subtracting the cost basis from the sales price. That cost basis is generally the original purchase price plus any capital improvements. If you replace a few shingles on your roof, it is a repair. However, if you replace the whole roof, that’s a capital improvement. If you don’t have receipts for the capital improvements, you can use reasonable estimates. However, the IRS may not accept them, if you’re audited. Inherited property, however, receives a “step up” in cost basis equal to the fair market value as of the date of death. This means that the original purchase price of the property and any capital improvements prior to the date of death are no longer relevant.
If property is sold after it is inherited, the profit is calculated by deducting the date of death value from the sales price with an adjustment for any capital improvements made to the property after the date of death.
As far as the mother’s life estate in the home, this is a special type of interest in real estate, where the mother retained the exclusive right to live on the property for her lifetime. However, a remainder interest is given to someone else, typically a child, such as the son in this example. This “remainderman” automatically becomes the owner of the property upon the death of the life tenant.
Even with the life estate, a property receives a full step-up in cost basis upon the death of the life estate owner. The first $250,000 of profit on the sale of a primary residence is also exempt from income tax, as long as the seller owned the property and lived in the home for at least two out of the last five years.
As such, the basis of the home will be the fair market value of the home in 2016, when the son inherited it as the remainderman of the life estate deed, plus any capital improvements he made since then.
In this situation, because the son has owned and lived in the house for two out of the last five years, he can exclude up to $250,000 of profit over and above the fair market value of the home on the date of the mother’s death. With estimated sale price of $375,000, he shouldn’t owe any capital gains tax.
Reference: nj.com (Dec. 31, 2020) “Will sale of inherited home cause a tax liability?”
