and the Home Sale Gain Exclusion
AUGUST 2006 - In
1997, IRC section 121 established one of the most beneficial
planning devices in the Tax Code. Married couples who have
owned and used a dwelling as their principal residence for
two years or more during the five-year period ending on the
date of the sale of the home are able to exclude up to $500,000
of realized gain. The exclusion limit for a single taxpayer
is $250,000. This home sale gain exclusion has allowed the
vast majority of taxpayers in most of the country to avoid
taxation from the sale of their dwelling. Due to recent significant
increases in home prices, however, especially for taxpayers
living along the coasts, the half-million-dollar exclusion
may not be adequate.
sale of a home can be complicated when it is undertaken
upon the death of a spouse. Sometimes the sale is the surviving
spouse’s choice, while other times health or financial
issues may force the decision. Surviving spouses who inherit
an interest in a significantly appreciated dwelling may
be impacted by a number of factors, including the dwelling’s
location (situs), the source of funds used to acquire the
residence, the timing of the sale, and the estate tax rules.
and Community Property States
states, including New York, New Jersey, and Connecticut,
follow common-law rules with respect to marital property.
Only nine states (Arizona, California, Idaho, Louisiana,
Nevada, New Mexico, Texas, Washington, and Wisconsin) subscribe
to the community property rules. Alaska allows residents
the option to place property into a community property trust.
Tax professionals who practice in common-law states need
some understanding of the subtleties of community property,
however, because it may significantly affect their clients
who have relocated, under the following two conditions.
example, consider a husband and wife who lived in California
and had their home titled as community property in 2001.
They moved to New York State in 2006 and rented out the
house in California. Soon after establishing domicile in
New York, one of the spouses died. Even though the surviving
spouse lives in New York, the real property is located in
California, and community property rules may determine the
surviving spouse’s basis in the inherited property
and the recognized gain from the subsequent sale of the
dwelling. Second, if a married couple uses assets acquired
in a community property state to purchase a new home in
for example, New York, community property rules may allow
for the full exclusion of all gains when the New York residence
is sold by the surviving spouse, even if the realized gain
is greater than the $500,000 limitation.
states that follow the community property rules, most assets
acquired during a marriage are presumed to be community
property, meaning each spouse owns half. Exceptions exist
in many community property states for separate property
owned before the marriage, received by gift, inherited during
the marriage, or acquired while living in a common-law state.
Some community property states, such as California, allow
residents to bypass the community property rules by titling
property in a common-law form, such as joint tenants or
tenants by the entirety.
if property is taken in common-law form, Revenue Ruling
87-98 allows residents of community property states to return
the property to community property status if allowed under
state law. For example, in California, property originally
titled as joint tenants can be converted into community
property, with both spouses’ written approval. Thus,
one may assume that state law, not the IRC, provides the
limiting factor in a married couple’s ability to elect
into the community property arrangement.
rules for determining the treatment of community property
when it crosses state lines are not well developed and are
quite complex. Two rulings from New York courts, however,
suggest that a taxpayer living there may be able to convert
property in New York to community property form. In Stein-Sapir
v. Stein-Sapir [382 N.Y.2d 799 (N.Y. App. Div. 1976)],
a divorcing couple domiciled in New York had been married
in Mexico. Mexico required the couple to elect community
or separate property. The couple elected community property,
and the New York court ruled the election valid and divided
the marital assets, located in New York, according to community
property rules. In re: Estate of Billy Martin [686
N.Y. 2d 195 (N.Y. App. Div. 1999)], the baseball star used
community property earned in California to purchase a home
in New York. The New York home was titled in the form of
tenants by the entirety. The Martins had executed an agreement
indicating their desire to convert all property held as
joint tenants, or as tenants in common, back into community
property. Because the agreement did not specifically mention
property held as tenants by the entirety, the New York court
disallowed the conversion.
income tax purposes, if a taxpaying couple who live in a
community property state elect to file as married filing
separately, each spouse must include one-half of the total
income earned by the couple, regardless of which spouse
actually earned the income. The division of income derived
from noncommunity property is divided based on state law.
For example, consider a husband who earns $60,000 from employment
and receives $10,000 in rent from a duplex he purchased
before the marriage. His wife earns $80,000 from employment.
In all community property states, each spouse includes $70,000
from earned wages. In Texas, Idaho, Louisiana, and Wisconsin,
both husband and wife would include $5,000 each of rental
income. In the other community property states, the husband
would include all the rental income. IRS Publication 555
provides a useful reference to these rules.
respect to inherited property, the issues are even more
significant when a surviving spouse sells the home. IRC
section 1014(b)(6) gives a significant advantage to couples
who hold property in community property form. When a spouse
dies in either type of state, the basis of the property
in the deceased spouse’s estate is bid up to fair
market value (FMV). But, for community property, the surviving
spouse’s one-half share is also bid up to its FMV.
In effect, the surviving spouse’s share of the community
property is considered to have passed from the decedent.
example, consider a husband and wife who live in California
and purchased a residence in 1989 for $100,000 with community
funds and titled it as community property. Each is assumed
to own one-half, giving them each a $50,000 basis. The husband
dies, when the FMV of the property is $1,500,000. The wife’s
basis in her property interest is also bid up to FMV, along
with the portion she receives from her husband’s estate.
Her new basis is $1,500,000. The husband’s estate
includes one-half of the FMV of the home at the time of
death ($750,000), which would be excludable under the marital
deduction. If the wife subsequently sells the property for
FMV, she would recognize no gain. In addition, she could
use IRC section 121 to exclude additional future appreciation.
contrast, consider a husband and wife who purchase a home
in New York for $100,000 and take title as joint tenants.
The wife receives the property when her husband dies, when
it is worth $1,500,000. Under IRC section 2040(B)(1), for
joint tenancies created after 1977 involving spouses, each
spouse is deemed to have contributed equally to the purchase
of the property. The wife’s basis ($50,000) in her
own interest does not change. The portion she receives from
her deceased husband is bid up to FMV. Thus, her new basis
is $800,000 ($50,000 + $750,000). The husband’s estate
includes $750,000, which is excludable by the marital deduction.
If the wife elects to immediately sell the home for $1,500,000,
she will have a realized gain of $700,000. Her recognized
gain will depend upon when she sells the dwelling.
of the Sale
the latter example, if the sale is made in the year of the
spouse’s death and the wife files a joint return under
IRC section 6013(a)(3), then $500,000 of gain is excluded
by section 121, leaving her a recognized gain of $200,000.
If the wife waits until the next year to sell the property,
a joint return cannot be filed, and she is only entitled
to exclude $250,000, resulting in a recognized gain of $450,000.
Thus, a taxpayer who delays the sale would face tax consequences
which may make it vital for a surviving spouse to dispose
of the property in the year of the partner’s death.
And if the spouse dies in the later part of the year, it
may be logistically difficult to dispose of the property
in time to qualify for the larger maximum exemption.
contrast, if the property is classified as community property,
the surviving partner’s basis is bid up to the FMV
of the property and there is no need to sell the property
in the year of the spouse’s death. A sale for FMV
would not result in a realized or a recognized gain.
but potentially beneficial, rule for those residing in common-law
states applies only when the property was acquired prior
to 1977 by the couple and more than one-half of the funds
originally used to pay for the house came from the deceased
spouse. For example, consider a married couple who bought
a home in a common-law state for $100,000 in 1975, with
the husband and wife named as joint tenants. The husband
provided all the funds for the purchase. He dies in 2006,
when the house is worth $1 million. Under Hahn v. Commissioner
[110 TC 140 (1998)], if the wife can prove that her husband
had supplied all the original funds, all of the house would
be included in his gross estate and its basis would be bid
up to its $1 million FMV in the wife’s hands. Thus,
under these limited circumstances, a taxpayer would be in
the same favorable position as a surviving spouse who resides
in a community property state.
of the Estate Tax
from 2006 to 2008, individuals can pass up to $2 million
through their estates before being subject to the estate
tax. An unlimited exclusion exists for property passed to
charities or to the spouse of the deceased. The exemption
equivalent is scheduled to increase to $3,500,000 in 2009.
The estate tax is scheduled to disappear entirely in 2010,
but due to a sunset provision in the tax law, the estate
tax will reappear in 2011 and the exemption will return
to $1 million.
the marital deduction is unlimited, any interest in a home
(or any other asset) passed to a surviving spouse would
not trigger estate taxes. There is no limitation on how
large the step-up in basis can be for any beneficiary. After
2010, however, this rule is scheduled to change. If Congress
does not alter the law, the basis of inherited property
can be stepped up by a maximum of $1,300,000. Assets left
to a surviving spouse would qualify for an additional $3
million step-up in basis. For example, consider a wealthy
couple who live in a common-law state and own, as joint
tenants, a mansion with an FMV of $20 million. Assume
each spouse has a $1 million basis in the property. In 2011,
the husband dies and the wife inherits his share. The unlimited
marital deduction will continue to eliminate estate tax
liability, but the wife’s new basis in the dwelling
would be limited to $6,300,000 ($1 million + $1 million
+ $4,300,000). If the husband had died before 2010, the
wife would have instead had an $11 million basis.
with the generous exclusion of IRC section 121, many taxpayers
will face tax consequences upon the sale of their residence.
Tax advisors should consider the following items if a significantly
appreciated home is part of a taxpayer’s financial
If a taxpayer lives in a common-law state and the marital
home has greatly appreciated in value, the surviving spouse
may need to sell the dwelling within the year of the spouse’s
death to minimize any recognized gain.
If a couple lives in a common-law state but owns a dwelling
in a state that recognizes community property, steps should
be taken to ensure that the property retains community
property status. Because the laws of every community property
state differ, consult with an estate planning expert in
the state where the dwelling is located.
of community property states who have opted out of community
property ownership by titling their home in common-law
form can ensure a stepped-up basis for the surviving spouse
by returning their property to the more beneficial community
property rules. The necessary procedures will vary among
Residents of common-law states who purchased their home
before 1977 as joint tenants may be able to use the Hahn
decision to lower any recognized gain upon sale by obtaining
a larger basis for the surviving spouse.
who purchase homes in common-law states may be able to
opt into community property if the assets used to purchase
the dwelling were earned within community property states.
For example, a couple who sell their home in California
and use the proceeds to purchase one in New York may be
able to use the Martin and Stein-Sapir decisions
to their advantage.
taxpayers who have always lived in common-law states,
one risky strategy would be to retitle a jointly held
home by naming as the sole owner the spouse who is expected
to die first. If the couple has guessed correctly, the
interest passes through the estate of the deceased spouse
and the survivor receives a new basis equal to FMV. For
this strategy to be effective, IRC section 1014(e) requires
that the now-deceased spouse must have lived for at least
a year following the conveyance. If the couple has guessed
incorrectly, however, the surviving spouse would not receive
any step-up in basis.
Unless modified by Congress, the changes in the estate
tax that arrive after 2010 will eliminate the unlimited
step-up in basis at death, which may have significant
negative tax consequences for the wealthy when an extraordinary
home is inherited by a surviving spouse.
Moore, PhD, JD, is an associate professor of accounting
and business law at Georgia College and State University,