QMy mother died three years ago and my father died a year later. My father's will left everything to my two sisters and me. One of my sisters has been living in my parents' house for the past four years. I am the executor of the estate, but have not yet transferred the title. We are all in agreement that the house should be hers.
My question concerns the capital gains treatment. If my sister sells the house less than two years after the title is transferred to her, will she have to pay capital gains tax on the difference between her sales price and the value of the house either on the day my father died or when the property was transferred to her? Alternatively, will the fact that she has lived in the house before and since my father's death allow her to claim the $250,000 exemption?
AYour question raises a host of issues.
First, did your mother and father own the property either as tenants by the entirety or as joint tenants? If so, the property automatically vested in your father upon your mother's death, which means that your father's will controlled the disposition of the house upon his death. However, if your parents owned the title as tenants in common, then on your mother's death, her interest in the property would have to have been probated. Please have your probate lawyer confirm the status of title.
In most states in this country, the executor (also called a personal representative) will automatically obtain title to the property on the death of the owner, and will either have the authority to sell the property or convey it to the beneficiaries named in the will. If there is no will, each state has laws (called "intestacy laws") that control how property is to be distributed.
No matter where title is, your father's will directed that the house go to you and your sisters.
Let's move to your specific question. Let us assume that your parents purchased the property 25 years ago for $50,000. Let us also assume that they made no improvements to the property. Additionally, assume that when your mother died, the property was appraised at $300,000, and on your father's death it was appraised at $400,000.
In any discussion of capital gains tax, we have to determine what is known as the "basis" of the property. Basis is generally defined as the initial purchase price, plus any improvements, less any depreciation that has been taken. In our example, there were no improvements, and because this was not an investment property, there was no depreciation.
However, there is a concept known as the "stepped up" basis. Oversimplified, this means that the basis is the fair market value on the date your father died. There is an alternative valuation method that is too complicated to explain in this column, but it could allow the basis to be determined at a date six months after the death.
Thus, when your father died, the basis of the property was $400,000, or $133,333 for each of his children. Do you plan to give one of your sisters the entire house as a gift, or do you plan to sell her your respective interests? If you want to give your share to her, then you will have gift tax consequences. Although you will not have to pay any gift tax, you will have to file a Gift Tax Return with the IRS, and this could have significant consequences for you -- and your estate -- down the road.
If, however, you sell your interests to her based on a total price of $400,000, you would have no capital gains tax to worry about. As we have discussed, your collective basis in the property on the date your father died was $400,000 and you are selling the property for this same price, so you will make no profit and thus will not have to pay any tax. However, under this scenario, your sister would have to pay the estate $266,666 -- the difference between the market value of $400,000 and her one-third interest in the property.
Before you make any decision, you and your other sister each should consult with tax advisers to make sure that you are protected financially.
As for your sister who plans to live in the house, we have to determine her basis. On the date of your father's death, her basis was $133,333. If you and your sister give your interests to her, her basis will become $400,000. The basis of the donor (the person giving the gift) becomes the basis of the donee (the gift recipient).
Your final question was about your sister's eligibility for the $250,000 exemption if she sells within two years of taking title. The answer is no. To be eligible for the up-to-$250,000 exclusion of gain ($500,000 if you are married and file a joint tax return) she must have owned and lived in the property for a period of two out of the five years before the property is sold. You sister will not be considered the "owner" until the title to the property is in her name.
The IRS recently issued rules regarding sales that occur before the two years have expired. If your sister has to sell, for example, for health reasons, or because she has a job transfer out of the area, she may be eligible for a pro-rated exemption.
This is a complicated situation. You obviously want to do right by your sister, but you do not want to create future problems for yourselves. The bottom line: You and both of your sisters must get specific tax and legal advice now, before the property is transferred.
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.