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Would Life Estate Have an Impact Taxes on an Inherited Home?

Nj.com’s recent article entitled “My mom added us to her deed and then died. Do we owe taxes?” explains that assuming mom retained an interest in the house or lived in the house after putting her children’s names on the deed, the IRS considers the property to be part of the taxable estate of the mother.

That is a critical point, when it comes to the amount of tax the children may have to pay.

She most likely kept a “life estate” in the home. This is where a person owns the property only through the duration of their lifetime. It is called “a tenant for life” or a “life tenant.”

A life estate is a restriction on the property because it prevents the beneficiary (usually the children) from selling the property that produces the income before the beneficiary’s death.

When the mom passes away, the life estate automatically stops and the children now have all of the rights associated with the property. As to income tax, when the parent dies, the property receives a “step up” in basis to the date of death value.

If the mom in our example had a life estate, the children would receive a “step up” in basis to the fair market value of the property on the date of death.

That means that the capital gain that would be taxed to the children would be the difference between the fair market value of the property when their mother died and the net proceeds of the sale.

Retaining the life estate can help a child avoid the capital gains tax more effectively than a simple transfer of the property outright to the child.

Talk to an experienced estate planning attorney about life estates and taxes, when you inherit a home.

Reference: nj.com (Feb. 18, 2021) “My mom added us to her deed and then died. Do we owe taxes?”

What are My Taxes on a House I Inherited?

Say your mom transferred the deed of the house over to you in November 2014 with a life estate for her. She dies in 2016. Mom paid about $18,000 for the home in 1960. This is the son’s primary and only residence. He wants to put the house on the market for $375,000. Will he have to pay capital gains tax?

The son probably won’t owe any tax on the sale of the house. Nj.com’s recent article entitled “Will sale of inherited home cause a tax liability?” explains that the profit can be calculated, by subtracting the cost basis from the sales price. That cost basis is the original purchase price plus any capital improvements.

As far as the son’s repairs, he should look at capital improvements, which is somewhat nebulous. The IRS definition is “add to the value of your home, prolong its useful life, or adapt it to new uses.” Any improvements must be evident when you sell. If you replace a few shingles on your roof, it is a repair. However, if you replace the whole roof, that’s a capital improvement. If you don’t have receipts for the capital improvements, you can use reasonable estimates. However, the IRS may not accept them, if you’re audited.

Inherited property receives a “step up” in cost basis to the fair market value as of the date of death. This means that the original purchase price of the property and any capital improvements prior to the date of death are no longer relevant.

If a property is sold after it is inherited, the profit is calculated by deducting the date of death value from the sales price with an adjustment for any capital improvements made to the property after the date of death.

As far as the mom’s life estate in the home, this is a special type of real estate ownership, where the owner retains the exclusive right to live in the property for as long as she’s alive. However, a remainder interest is given to someone else, like a child. This “remainderman” automatically becomes the owner of the property upon the death of the life tenant.

Even with the life estate, the home receives a full step-up in cost basis upon the death of the life estate owner. The first $250,000 of profit on the sale of a primary residence is also exempt from tax, as long as the seller owned the home and lived in the home for two out of the last five years.

As such, the basis of the home will be the fair market value of the home in 2016, when the son inherited it as the remainderman of the life estate deed, plus any capital improvements he made since then.

In this situation, because the son has owned and lived in the house for two out of the last five years, he can exclude up to $250,000 of profit. With estimated sale price of $375,000, he shouldn’t owe any capital gains tax.

Reference: nj.com (Dec. 31, 2020) “Will sale of inherited home cause a tax liability?”

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