QMy sister died in January 2000. She owned and lived in a cooperative apartment in New York for many years, until her death. As executor of her estate, I sold her shares in the apartment in February 2001. Does this event fall under the sale-of-personal-residence rule and qualify for the exclusion of $250,000 of capital gain to my sister?
If this cannot be considered as a sale of my sister's principal residence, is the inherited property a business investment transaction for me? As sole heir, I inherited her estate, but the cooperative apartment shares were never transferred to my name. I had the apartment appraised as of the date of death and continued to pay all expenses for the maintenance and preparation of the apartment for sale.
AYour first question is easy. No, the estate is not able to take advantage of the principal residence exclusion of up to $250,000 in capital gains tax (or $500,000 if the property owners are married and file a joint tax return).
The estate did not, and could not, live in the apartment for two out of the last five years before the apartment was sold. The tax laws will not permit that principal residence exclusion. Depending on local law, on your sister's death, you as executor became the owner of the apartment.
Here, the concept of the "stepped-up" basis comes into play. Oversimplified, that means the basis of inherited property for income tax purposes is the fair market value of the property at the time of the decedent's death -- that is, it's stepped up, or increased, to that level.
By way of illustration, if your sister bought her apartment 17 years ago for $50,000 and over the years made $25,000 in improvements, her basis for tax purposes would have been $75,000. If she had sold the property before her death for $325,000 or less, she would not have had to pay any tax on her gain. As described above, a taxpayer who lives in her house for two years before it is sold can exclude up to $250,000 in gain from tax ($325,000 minus 75,000 is $250,000.)
However, your sister did not sell the property. Thus, on her death, you -- as her sole heir -- received the benefit of the stepped-up basis rule. Now that you have sold the apartment, you will have to pay tax only on the difference between the market value on the day of death and the actual sales price.
If the value of her property on the date of her death had increased to $500,000, and you sold the apartment for that price, no federal income tax would be owed.
Keep in mind that we are only discussing income tax and not inheritance tax or any New York state taxes applicable to estates.
According to the federal tax code, the stepped-up basis applies to property "acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent." This means that whether the decedent has a will or dies intestate (without a will), the beneficiary is eligible for that stepped-up basis.
There is, however, an alternative valuation rule that can be adopted. This alternative valuation gives the taxpayer the choice of whether to value the property six months after the date of death or at the date of disposition, if that's earlier.
The purpose of this election is to afford some limited tax relief to estates in cases in which the value of the assets decline during that six-month period.
Your sister could have given the property to you before her death, but in my opinion, this would have been a huge mistake.
Let's look at this example: We have decided that her tax basis was $75,000. Had she given you a gift, your basis for tax purposes would be the same as the grantor -- i.e., $75,000. Say that you subsequently sold the apartment for $500,000. Because you did not live in the property for at least two years, you would have to pay capital gains tax on $425,000. At the current tax rate of 20 percent, this means that the federal government would have been given a gift of $85,000.
Instead, when you inherited the property, you received the benefit of the stepped-up basis. If you sold the property at that same valuation, you did not have to pay any capital gains tax at all.
Obviously, the decision on whether to sell one's property while living or pass it on to your heirs is a very important -- and personal -- choice. Some people want to make sure that their heirs will be properly protected on their death. Other people might very well want to make sure that they are protected while they are living.
Either way, the tax consequences are -- or should be -- an important part of the decision.
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.