After living in the house for over fifty years, Harry and Sally’s love for the home wasn’t the only thing that appreciated – so had the value! Sally’s realtor priced it at $750,000. It was time to paint not only the trim, but also time to trim the tax liability!

When Harry met Sally, they bought a wonderful home for $50,000. They loved their home, neighborhood, and the fond memories created there. When Harry passed away, Sally decided it was time to move because the home was too big and required too much maintenance.  With the house value going from $50,000 to $750,000, Sally wondered what the tax consequences might be.

Home Capital Gain Calculation Refresher

Since 1997, any gain realized on the sale of your residence is subject to taxation. However, qualifying individual homeowners can exclude up to $250,000 of gains, and joint owners can exclude up to $500,000. So, if you profit $250,000 or less ($500,000 or less for joint owners), you will not be subject to capital gain tax. 

To be eligible for the exclusion, you must meet all of the following requirements:

  • You are selling your primary residence;
  • You have owned the house for at least two years;
  • You have lived in the house as your primary residence for at least two out of the last five years.
  • You can only use the exclusion every two years.

If you do not meet all of these requirements, you will owe tax on the capital gain realized from the sale of your residence.

Sally Sells the Home

Sally meets all the requirements to qualify for the exclusion and starts to calculate! The first thing she needs to figure out is the cost basis of the home. The basis is the price they paid for the home, plus the cost of improvements made over the years.

Sally and her husband purchased the home for $50,000. Over the years, they remodeled the kitchen, bathroom, added a family room and outdoor living area, and replaced the windows. All those renovations totaled $260,000, so the cost basis of the home is actually $310,000.

If the home sells for $750,000, Harry and Sally would not owe any capital gains tax because the gain on the house is $440,000, which is under the $500,000 married filing joint limit. But wait, Harry is deceased, and Sally now owns the home individually, right? Isn’t her capital gain exclusion limited to $250,000?

Harry Steps Up

Harry and Sally owned the home joint with the right of survivorship, therefore, when Harry passed, the home automatically transferred to Sally. Thus, at his passing, Harry’s 50% ownership of the house received a step-up in basis to the current market value of the home.

How does Harry’s step-up help? Remember, they purchased the home for $50,000, and when Harry died, the home was worth $750,000. When Harry’s half transferred to Sally, his basis wasn’t $25,000 (half of the purchase price), it was $375,000 (half the current fair market value).  Therefore, when Sally sells the home for $750,000, the capital gain on the sale is $220,000 – under the individual $250,000 exclusion amount. Here’s how that value was calculated:

  • Harry’s stepped up cost basis = $375,000
  • Sally’s cost basis = $155,000 ($25,000 purchase price + $130,000 of improvements. Sally can add 50% of the home improvements they made over the years.)
  • New cost basis of home = $530,000 ($375,000 + $155,000)
  • Capital gain = $220,000 ($750,000 sale price – $530,000 cost basis)

Sally’s $500,000 Exclusion “On the Side.”

If Sally sells the home within two years of Harry’s death, she will qualify for the $500,000 capital gains exclusion since she meets all the previously listed eligibility requirements.

Summary

Fortunately, Sally talked with her financial advisor and learned about the step-up basis rule when selling her home, and it saved her a significant amount on taxes. This strategy is often overlooked, so be sure to consult with your financial or tax advisor when selling your home to make sure you don’t pay taxes unnecessarily! 

Meredith Carbrey, CFP, is a Senior Wealth Advisor with Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Meredith at mcarbrey@bedelfinancial.com