Death and the Home Sale Gain Exclusion

By Tom Moore

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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.

The 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.

Common-law and Community Property States

Forty-one 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.

For 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.

In 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.

Even 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.

The 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.

For 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.

With 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.

For 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.

By 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.

Timing of the Sale

In 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.

By 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.

A limited, 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.

Role of the Estate Tax

Generally, 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.

Because 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.

Tax Advice

Even 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 portfolio:

  • 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.
  • Residents 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 states.
  • 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.
  • Couples 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.
  • For 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.

Tom Moore, PhD, JD, is an associate professor of accounting and business law at Georgia College and State University, Milledgeville, Ga.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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