What if a husband and wife jointly own a house that increases in value by $500,000? Does one spouse receive an increase if one spouse dies and the other owns the property? Or will they only receive a $250,000 capital gains exemption if they sell the property?
– Samuel
Your question concerns the rules surrounding both an increase in the basis of an inherited asset and the exclusion of capital gains on the sale of a main home. These rules are separate, so they are both true: the surviving spouse gets a step-up basis And they only receive a $250,000 exemption. That might sound a little confusing, so let’s unpack it below.
If you have similar questions about tax planning or need help managing your investments, consider talking to a financial advisor to see how they can help you.
In the financial world, the term “basic” usually refers to the amount you pay for something. Basis is important because it is the starting point from which you calculate taxable profit. For example, say you buy something for $100,000, that’s your basis. If the value of the asset grows to $150,000 and you decide to sell it, you will owe tax on the $50,000 capital gain.
An increase in basis occurs when the basis of an inherited asset is reset to its market value at the time the original owner (or co-owner) dies. In other words, when someone inherits assets such as stocks or real estate, the tax basis is adjusted to reflect the value of the asset at the time of the owner’s death, rather than the amount originally paid for it.
Returning to the example above, suppose you have an asset with a base value of $100,000, and by the time you die, its value has increased to $150,000. Instead of inheriting your original basis, your heir will receive an ‘increased’ basis. In this case, their new basis is $150,000, and they will realize no gain unless the property continues to appreciate in value.
(Tracking basis step-up is an important part of tax planning and estate planning. A financial advisor with expertise in both areas may be able to help you exploit this tax loophole.)
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The tax law allows you to reduce or avoid capital gains taxes on the sale of a primary residence, provided you have lived in it for two of the past five years. This tax benefit is known as the Section 121 exclusion.
There are parameters you must stay within to qualify for this tax break, but the broad strokes are as follows:
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Individuals can exclude up to $250,000 in gain from the sale of a primary residence
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Couples filing a joint return can exclude up to $500,000 from the sale of a primary residence
So let’s say the basis for your primary home is $300,000. If you’re single, you can sell it for up to $550,000 without having to pay capital gains taxes. A married couple could sell it for up to $750.00. In this example, transaction costs are ignored to provide a simplified illustration. You should work closely with your tax professional to ensure that you calculate your basis correctly. (And if you need help finding a financial professional, this free tool can connect you with three fiduciary advisors serving your area.)
Samuel, to see how both rules apply in the situation you’re asking about, we need to think of them in the following order:
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First determine the stepped up base
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Secondly, calculate the taxable profit taking into account the exclusion under section 121
The surviving spouse receives an increase upon the death of the first spouse. However, the value of that adjustment depends on whether they live in community of property. In a community property situation, the surviving spouse receives a full step-up basis. This means that their basis becomes the fair market value of the property at the time their spouse died.
In a non-common law state, the surviving spouse only receives an increase equal to half the value of the property. For example, the couple’s joint basis is $300,000, but the house is worth $500,000 when the first spouse dies. Half of that $200,000 gain is added to the surviving spouse’s basis, giving them a $400,000 basis on a house worth $500,000.
After the surviving spouse determines the increased basis of the inherited home, he or she can calculate how much the taxable gain would be if he were to sell the home. And remember, they only owe capital gains tax on the portion of those gains that exceed the Section 121 exclusion.
Here’s a final example to bring it all together:
A couple living in community of property owns a home worth $500,000 even though they originally paid $300,000 for it. The first spouse dies and the surviving spouse’s tax basis increases to $500,000. The surviving spouse can then sell the home for up to $750,000 without recognizing a taxable gain due to the $250,000 exclusion.
One final nuance: the exclusion amount depends on tax filing status. “Married filing jointly” status gets a $500,000 exclusion, while “single” status gets a $250,000 exclusion. Widows and widowers may retain their joint married filing status in the year of death. So the surviving spouse may still be able to exclude the entire $500,000 if he sells the property in the same calendar year that his spouse dies. (But if you need extra help with your tax strategy, consider working with a financial advisor with tax expertise.)
When one spouse dies and the surviving spouse decides what to do with their joint home, it is important to understand the rules for the stepped-up basis and capital gains tax exclusion. A surviving spouse receives an increase in basis that can adjust the inherited home to its fair market value at the time of his/her spouse’s death. If they were to sell it, they could still apply the Section 121 exclusion and avoid tax on up to $250,000 in capital gains – and in some cases $500,000 – on the sale of the house.
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If possible, consider delaying the sale of appreciated investments until you are in a lower tax bracket, such as after retirement. Long-term capital gains are taxed more favorably, and if your income is low enough, you may qualify for a 0% capital gains tax rate. Try our capital gains tax calculator to see how much you might owe when you sell your assets.
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A financial advisor with expertise in tax planning and/or financial planning may be able to help you determine the best time to sell assets to minimize the tax consequences of the sale. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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Brandon Renfro, CFP®, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Brandon is not an employee of SmartAsset and is not a participant in SmartAsset AMP. He received compensation for this article. Some reader-submitted questions have been edited for clarity or brevity.
Photo credits: ©iStock.com/skhoward, ©iStock.com/LumiNola
The post Ask an Advisor: When My Spouse Dies, Will I Get a Full Basis Increase on My Home or Just the $250,000 Capital Gains Exemption? first appeared on SmartReads by SmartAsset.
