Inheritance Laws Can Work in Your Favor

Q: I live in Maryland. My father passed away in January, and I have inherited his townhouse. He had a mortgage. I am continuing to make the mortgage payments. I have not notified the mortgage company. I am unable to obtain financing for a home in my name at this time and was turned down for home loans twice. If the lender finds out that I now own the house, can they pull the loan? I don't want to lose the house. There was a will, and I had a lawyer prepare the deed, which was properly recorded in my name. If I sell the home and pay off the mortgage, are there capital gains taxes or other taxes that I may have to pay? It was my father's wish that the house be mine upon his death, yet I am afraid that if I notify the mortgage company, they will pull the loan.

A: You have nothing to worry about as long as you continue to pay the mortgage.

I suspect there is a "due on sale" clause in your father's mortgage. Such a clause states that the lender can call the entire loan due if the property is sold or otherwise transferred without the lender's consent.

However, since 1982, federal law has prohibited lenders from enforcing such clauses when a borrower dies and the property is transferred to a relative.

Thus, your lender cannot call that loan due as long as you remain current with the obligations. Advise the lender that you are the new owner, and send a copy of the deed. You want the lender to start sending you the mortgage payment coupons. More important, at the end of each year, lenders are required to send borrowers and the IRS a statement detailing the amount of interest and real estate taxes paid that year. You want to make sure that this statement is in your name, with your Social Security number. Otherwise, the IRS may question why you are deducting mortgage interest.

You asked about taxes if you sell the house. In that situation, the concept of "stepped-up basis" comes into play. This means that when a person inherits real estate, his or her tax basis is the value of the house on the date of death. (Note: It can also be based on the value six months after death, but you have to discuss this with your tax advisers.) The gain on the sale of a house -- that is, the amount that might be taxable -- is essentially the difference between the sales price and the tax basis.

Here's an example: Say your father bought the property with your mother many years ago for $30,000. The basis for your father and mother was $15,000 each. Then, say your mother died in 2000, when the property was worth $200,000. After her death, your father would have received the stepped-up basis of half of the value, or $100,000, thereby increasing his basis to $115,000. If he had sold the house during his life, that basis would have been used to determine whether he had a taxable gain.

Say that when your father died, the house was worth $400,000. That would become your basis when you inherit. If you sell it for that amount, you will not have made any gain, and thus would not have to pay any capital gains tax. Should you sell for more, your gain would be taxed at 15 percent for federal tax, plus whatever state tax applies.

However, if you decide to live in the house, you might eventually be eligible to take a chunk of tax-free profit when you sell in the future. If you both own a house and use it as your principal residence for two out of the five years prior to a sale, up to $250,000 of profit can be excluded from capital gains tax ($500,000 if you are married and file a joint tax return).

So let's say that you decide to sell the house three years from now, when it is worth $500,000. Assuming that you did not make any improvements to the property -- which would increase your tax basis -- and ignoring closing costs and commissions, which would reduce your profit, you would have made a gain of $100,000 ($500,000 minus your basis of $400,000).

Because that is below the $250,000 ceiling, you would not have to pay any capital gains tax.

Mortgages and tax laws are complex, but in your case, it appears that things will come out in your favor.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.