Let’s say you’ve known for years that you are inheriting your father’s home when he dies.
Hopefully, you also know that he has a will that indicates clearly that the house will go to you.
Now let’s assume that your father is no longer living in the house and doesn’t need the money from the sale. Perhaps he just moved to assisted living and has long-term care insurance to cover the costs. Or maybe he just moved in with you and has enough retirement savings to cover his needs.
So when is the best time for your dad’s house to be sold: While he is still alive or after he dies?
Let’s consider the tax implications of the sale. As long as your dad has lived in his house for two of the last five years, it’s considered his primary residence under the Internal Revenue Code. That means that he can take advantage of the federal exclusion on capital gains tax. An individual taxpayer does not have to pay capital gains tax on the first $250,000 gain in the value of his or her home. A married couple does not have to pay capital gains tax on up to $500,000 in gains.
Assume the house was purchased for $25,000 in 1977. It’s now 2020 and it’s worth $825,000.
So far, that sounds great. Your dad stands to make an $800,000 profit.
He won’t have to pay capital gains tax on the first $250,000 in gains. But the tax will be applied to the $550,000 profit after the exemption. Also, in some states additional taxes would be owed.
Keep in mind that the situation looks different if your dad’s house is worth a lot less money, or if both of your parents are still alive. For a house with a gain of $250,000 or less ($500,000 or less for a married couple), your dad will avoid paying capital gains tax entirely if all conditions are met. Then, the amount of tax due on the sale could be relatively small, so your dad could choose to sell now and leave the proceeds to you at death.
When you sell the home after your dad passes, another highly beneficial rule comes into play — the step-up in basis at death rule. Under that rule, when a home is inherited after someone dies, the property value is “stepped up” to the fair market value at the time of death.
Take the example of your dad’s house. At his death, the Internal Revenue Code views the $800,000 gain in property value as the value of the property, rather than a taxable profit. That means you keep the money in your pocket when you sell it.
Generally, with a house that is likely to show a large gain you are better off encouraging a parent to leave the house to you so you can sell it when he or she passes.
If you wait to sell your dad’s house after he dies, the probate process could take several months or more. You can’t sell the house until it’s distributed to you after probate. Depending where you live and how much time passes, that means the house could increase in value before you sell. You will have to pay capital gains tax on the profit, because at that point your dad’s house is treated as your second home and doesn’t qualify for the federal exclusion on a primary residence.
There are a few ways to speed up this process, if you have the chance to help your parents make plans during life.
If your dad leaves his home to you in a revocable living trust that names you as the beneficiary, you won’t need to go through probate, can avoid some estate taxes and are in a position to sell the home right after your parent(s) dies.
Another option is a transfer on death deed, which is only available in certain states. This allows you to inherit the property right away, without going through probate. But you will still have to pay taxes on the house.
The Sensible Taxation and Equity Promotion (STEP) Act would get rid of what’s known as the step-up in basis to tax the unrealized gains of certain estates at death.
Step-up in basis refers to the way the value of an asset is readjusted for tax purposes upon inheritance.
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